Philip Greenspun (via Luke Froeb):I spent a few days recently in the company of some money managers with a total of about $2 trillion to invest, precisely the sort of folks whose confidence the government is currently trying to win. How did they feel about all of the rule and policy changes coming out of Washington and the new more muscular government? Terrified.The "real money" investors didn't want to invest alongside the government. Their concern is that if things go south, the government will take 100% of the value left in the bank or whatever and leave private investors, including recent ones, with nothing. This is precisely what happened to recent investors in Fannie Mae.The "real money" investors didn't want to see judges modifying contracts, e.g., bankruptcy judges resetting mortgage payments at a lower level and reducing the principal owed. As far as they were concerned, a central tenet of the U.S. Constitution is that people are free to make contracts. Given how mortgages are split up among investors, a foreclosure is greatly preferable to these folks than a modification. In a foreclosure the most senior investors get what they expected, i.e., their money back. The holders of the most junior tranches, which carried a higher return and were known to be high risk, would get nothing. This is also what they would have expected. If mortgages are modified by government action, however, it is unclear how the obligations among the various private parties should be adjusted.

The punch line:

Much of the justification for government intervention comes from the assertion that markets have failed. One money manager scoffed at this idea. "The markets are working fine, but they're giving people answers that they don't like, so people cry market failure." Stocks and bonds low? That's because investors are afraid of a prolonged depression and continued government interference. House in a jobless region of Michigan worth almost nothing? A place with 50% of its former jobs only needs 50% of its houses. There are plenty of former steel towns where the price of a comfortable house stabilized at $20,000 decades ago and has barely moved since.What did these guys want the government to do? Nothing, basically. "Back in the 19th Century, there were a lot of steep crashes, guys got wiped out, and the economy came back quickly." What's different now? The government is a lot bigger and more powerful. Rich companies and people can put some of their wealth into lobbying and demand that the government prevent them from getting wiped out (or at least slow the process).

O ye of little faith! This economic crisis is evidence that the market is working

Like skaters on a lake’s frozen surface, we are sometimes reminded how thin is the crust of philosophical confidence on which our systems of political economy rest. Two years ago we were mostly agreed that free market economics had won the ancient argument between capitalism and the planned economy. Two years ago the case for a single market for goods and labour within the European Union was widely thought unanswerable.

Yet everywhere we turn today, wise heads mutter that the global free market has failed. And (after some placard-waving at the Total refinery and beyond) we heard Alan Johnson, the Health Secretary, declare on the Andrew Marr programme on BBC television last week that labour from outside Britain might ‘undercut’ domestic workers — as if this ‘undercutting’ were a bad thing, rather than the very engine of a capitalist economy.

Mr Johnson was not challenged. No senior colleague came to the public support of Lord Mandelson, the Business Secretary, in his restatement of the obvious about the single market. Is our grasp of general principle so weak? Do politicians not understand that if we say workers should not travel to ‘undercut’ local labour markets, the corollary that cheaper goods should not travel to ‘undercut’ locally produced goods cannot be far behind? How can our confidence in Adam Smith have evaporated so fast?

It is true that part of the reason for our former philosophical certitude lay in results. Why doubt prevailing theories when we were demonstrably getting richer? By their fruits we should (we thought) know them; and even an ignoramus may, if medical science cures him, claim to ‘believe’ in its theoretical base.

But did our confidence go no deeper? Medical science may be hard to fathom, but political economy is not. We did not need to believe the latter by dumb faith alone: we surely understood the argument that underpins free market economics and the free movement of goods and labour. The theoretical case is, after all, so simple, and has been explained with such clarity by writers from Adam Smith onwards. The mechanisms by which markets work can be grasped by any 12-year-old.

So our confidence should have been solid not only because the free market was evidently delivering prosperity and growth, but because we understood why it must be the most efficient engine of wealth-creation. And if the market had then seemed to falter, we could still know this would only be a pause, a reculer pour mieux sauter, and feel reassured that, however stuttering the free market might be at delivering wealth, it would be more reliable than any rival system.

Or that is what we thought we believed. Yet now, after a setback which, though sharp, will turn very few of us out on to the streets, and require only a modest reassessment of what we are worth and how we can afford to live, we run around in philosophical panic, proclaiming our agnosticism or, worse, apostasy.

O ye of little faith! I feel as a priest must feel when a member of his flock abandons the faith because her child has died. Children (the priest might respond) do die; accidents do happen. You knew that. You knew when you embraced the faith. Theology has explanations for human suffering. You knew that too.

And world recessions do occur. You knew that. You were surely taught at school about the last big one in the first half of the 20th- century, and many smaller ones since. The theology of market economics has never denied that there could be sharp corrections and reverses; even, for a time, collapses. Indeed it explains them. You knew that too.

So amid all the doom-mongering and recanting, I have an assertion to make. The market has not failed. The present collapse is evidence that the market is working. Confidence bubbles are an inherent feature of a free market system. Panics — confidence vacuums — are an inherent feature too. The test of the theory of market capitalism is whether the system provides from within itself the means to prick both.

It does. The first — a confidence bubble — has been pricked. We are now sucking ourselves the other way: into a confidence vacuum. In time this too will be pricked. The market will steady.

The bubble that has just burst was based, worldwide, on financial services. Financial services are a product. It is true they are a product critical to the efficient functioning of the market (so is electricity, so is oil) but that just makes them an unusually important product. From time to time products fail in any market. They may fail through force majeure — droughts, floods, pestilence. They may fail due to inherent flaws — airships, Thalidomide, blue asbestos. Or they may fail through ignorance, trickery or the credulity of human beings — Madoff, the property bubble, the repackaging of sub-prime debt.

The present financial crash has been precipitated by product failure of the third kind. Trade in financial instruments too opaque for even those who traded in them to assess them properly, and bonus incentive schemes that acted against the interests of the companies offering them, fuelled a banking bubble that has now burst.

But ask: what pricked it? Did politicians rumble the trade? Did governments, or international forums or symposiums, provide the sharp instrument? Did academic research and expertise expose the dodgy product? Did statutory regulators apply the pin? No, the free market wised up and pricked this bubble. Politicians and finance ministers (if they had had the power) would have tried to keep it inflated. The market puffed itself up, and then, without intervention — despite intervention — the market let itself down. The speed with which this has happened has been awful, but however inconvenient for many or catastrophic for a few, correction is not a failure of the market, but a success.

New rules and regulations will now be brought in. This, too, is no failure of the market. Free markets require — often demand — limits to the exercise of their freedom. Since the beginning of commerce, society has collectively imposed curbs and safeguards on the market (the very introduction of a law of contract was the first and still by far the biggest act of regulation) and a handful more of these, minor in the context of economic history, will now be applied. There will be no ‘new economic world order’, just some useful tweaks to the old one.

The earth will continue in its orbit, and nature will resume its course. No re-examination of our governing theories of political economy is called for. Calm down, dear, it’s only a market correction.

Take a look at this chart depicting the monetary base on a monthly basis dating from 1917. This chart was cobbled together from data found on no fewer than three different websites managed by the Federal Reserve.

I read with a smile this article. But I have news for these folks thinking the funeral business is stable. It isn't. I have a patient who is in this business who is very anxious because business is bad. I asked him how business could be bad in this field. He said no one is splurging for anything other then the bare minimum. The cheapest caskets the cheapest funerals. The least expensive everything. Business is very bad.

So why are people dying to go into this field? It sounds like a phoney sales pitch from the schools to me:

***If nothing is certain but death and taxes, then funeral service may be the closest thing to a recession-proof career in these uncertain times.

Nowhere is that more evident than mortuary science programs like the one at Nassau Community College, where interest and applications have mounted as the economy contracts.

At Nassau, which offers the only such public program in the metropolitan area, inquiries about mortuary science are up 15 percent in recent months, and enrollment for last fall's class was nearly double the year before.

At the American Academy McAllister Institute of Funeral Education, a private program in Manhattan, enrollment has jumped to 270 students for the spring semester, compared with 200 a year ago. The school attributes the rise to the economic downturn and the addition of an online program. Worried about your money? Stay on top of Wall Street and local LI business stories "They're looking for something stable, a career that will last them," said Michael Mastellone, chairman of the Nassau program. "And there will always be work out there."

Among the recent inquiries Mastellone fielded was one from a retired police officer who at 57 wondered whether there was an age limit to start the two-year program.

"He retired and his pension was fine, and now his retirement fund isn't fine anymore," Mastellone said.

He said that about 80 percent of the program's graduates are employed in the funeral service industry. Graduates can earn about $50,000 a year by the time they complete a yearlong residency at a funeral home, he said.

The demographics don't hurt, either.

"I sometimes see a twinkle in the eye of some particularly entrepreneurial students . . . as they imagine what their future will be like with the aging of baby boomers," said Regina Smith, dean of the McCallister Institute in Manhattan, in an e-mail.

What's more, funeral directors are, on average, older than workers in most other occupations, which means they will be retiring in greater numbers over the next decade, according to a U.S. Department of Labor report.

"I think we have an extremely unique career," said John Madigan, 20, of Hicksville, a second-year student at Nassau. "Not many people can do it.

"A lot of the kids I graduated from high school with . . . now they're worried about whether they'll find a job. I'm still on track."

Nassau has an enrollment of 107 students, including part-timers - an increase of nearly 20 percent over this time in 2008. The fall 2008 class was about 50 students, twice what the school normally enrolls.

The program has attracted an eclectic mix of fresh-out-of-high-school students and second careerists, who shrug off stereotypes that the profession is ghoulish or maudlin.

"I get a lot of, 'Are you sure you want to do that?' " said Arielle Gallo, 22, a second-year student from Holbrook. She was inspired by the funeral director who handled the funerals of her grandparents, who died within two months of each other when she was in high school. "It's not really about hanging around deceased people. It's about caring for the families."

For Matthew Bennett, 37, getting laid off from his job as a personal assistant was the catalyst for pursuing a career he had always wondered about.

"Losing my job gave me that push," said Bennett, a second-year student who also lives in Holbrook. "I was in a good position to go to school full-time - and it's a good job."

By MARY ANASTASIA O'GRADY"What can we do that would be beneficial? [One thing] is lower corporate taxes and businesses taxes and maybe taxes in general. Particularly, you want to lower the tax on capital so you raise the after-tax return to investing and get more investing going on."

Gary Becker, the winner of the 1992 Nobel Prize in Economic Sciences, is in New York to speak to a special meeting of the Mont Pelerin Society on the global meltdown. He has agreed to sit down to chat with me on the subject of his lecture.

Ismael RoldanSlumped in a soft chair in a noisy hotel coffee lounge, the 78-year-old University of Chicago professor is relaxed and remarkably humble for a guy who has achieved so much. As I pepper him with the economic and financial riddles of our time, I am impressed by how many times his answers, delivered in a pronounced Brooklyn accent, include an "I think" and sometimes even an "I don't know the answer to that." It is a reminder of why he is so highly valued. In contrast to a number of other big-name practitioners of the dismal science, he is a solid empiricist genuinely in search of answers -- not the job as the next chairman of the Federal Reserve. What he sees is what you get.

What Mr. Becker has seen over a career spanning more than five decades is that free markets are good for human progress. And at a time when increasing government intervention in the economy is all the rage, he insists that economic liberals must not withdraw from the debate simply because their cause, for now, appears quixotic.

As a young academic in 1956, Mr. Becker wrote an important paper against conscription. He was discouraged from publishing it because, at the time, the popular view was that the military draft could never be abolished. Of course it was, and looking back, he says, "that taught me a lesson." Today as Washington appears unstoppable in its quest for more power and lovers of liberty are accused of tilting at windmills, he says it is no time to concede.

Mr. Becker sees the finger prints of big government all over today's economic woes. When I ask him about the sources of the mania in housing prices, the first culprit he names is the Fed. Low interest rates, he says, were "partly, maybe mainly, due to the Fed's policy of keeping [its] interest rates very low during 2002-2004." A second reason rates were low was the "high savings rates primarily from Asia and also from the rest of the world."

"People debate the relative importance of the two and I don't think we know exactly," Mr. Becker admits. But what is clear is that "when you have low interest rates, any long-lived assets tend to go up in price because they are based upon returns accruing over many years. When interest rates are low you don't discount these returns very much and you get high asset prices."

On top of that, Mr. Becker says, there were government policies aimed at "extending the scope of homeownership in the United States to low-credit, low-income families." This was done through "the Community Reinvestment Act in the '70s and then Fannie Mae and Freddie Mac later on" and it put many unqualified borrowers into the mix.

The third effect, Mr. Becker says, was the "bubble mentality." By this "I mean that much of the additional lending and borrowing was based on expectations that prices would continue to rise at rates we now recognize, and should have recognized then, were unsustainable."

Could this behavior be considered rational? "There is a lot of debate in economics about whether we can understand bubbles within a rational framework. There are models where you can do it, but it's not easy," he says. What he does seem sure about is that "the lending would not have continued unless there was this expectation that prices would continue to rise and therefore one could refinance these assets through the higher prices." That mentality was at least partly related to Fed action, he says, because the low interest rates "generated an increase in prices and I think that helped generate some of this excess of optimism."

Mr. Becker says that the market-clearing process, so important to recovery, is well underway. "Construction in new residential housing is way down and prices are way down. Maybe 25% down. Lower prices stimulate demand, reduced construction reduces supply."

That's the good news. But he complains about "counterproductive" government policies "designed to lower mortgage rates to stimulate demand." He says he was against the Bush Treasury's idea of capping mortgage rates (which was only floated) and he has "opposed the mortgage plan of President Obama." "It goes against both these adjustments . . . it would hold up prices and increase construction. I think that's a bad idea at this time."

Yet the professor is no laissez-faire ideologue. He says we have to think about what the government can do to "moderate the hit to the real economy," and he says it should start with "the first law of medicine: Do no harm." Instead it has done harmful things, and chief among them has been the "inconsistent policies with the large institutions . . . We let some big banks fail, like Lehman Brothers. We let less-good banks, big [ones] like Bear Stearns, sort of get bailed out and now we bailed out AIG, an insurance company."

Mr. Becker says that he opposed the "implicit protection" that the government gave to Bear Stearns bondholders to the tune of "$30 billion or so." So I wonder if letting Lehman Brothers go belly up was a good idea. "I'm not sure it was a bad idea, aside from the inconsistency." He points out that "the good assets were bought by Nomura and a number of other banks," and he refers to a paper by Stanford economics professor John Taylor showing that the market initially digested the Lehman failure with calm. It was only days later, Mr. Taylor maintains, that the market panicked when it saw more uncertainty from the Treasury. Mr. Becker says Mr. Taylor's work is "not 100% persuasive but it sort of suggest that maybe the Lehman collapse wasn't the cause of the eventual collapse" of the credit markets.

He returns to the perniciousness of Treasury's inconsistency. "I do believe that in a risky environment which is what we are in now, with the market pricing risk very high, to add additional risk is a big problem, and I think this is what we are doing when we don't have consistent policies. We add to the risk."

On the subject of recovery, Mr. Becker repeats his call for lower taxes, applauds the Fed's action to "raise reserves," (meaning money creation, though he said this before the Fed's action a few days ago), and he says "I do believe one has to try to do something more directly to help with the toxic assets of the banks."

How about getting rid of the mark-to-market pricing of bank assets [that is, pricing assets at the current market price] that some say has destroyed bank capital? Mr. Becker says he prefers mark-to-market over "pricing by cost because costs are often completely out of whack with what the real prices are." Then he adds this qualifier: "But when you have a very thin market, you have to be very careful about what it means to mark-to-market. . . . It's a big problem if you literally take mark-to-market in terms of prices continuously based on transactions when there are very few transactions in that market. I am a mark-to-market person but I think you have to do it in a sensible way."

However that issue is resolved in the short run, there will remain the problem of institutions growing so big that a collapse risks taking down the whole system. To deal with the "too big to fail" problem in the long run, Mr. Becker suggests increasing capital requirements for financial institutions, as the size of the institution increases, "so they can't have [so] much leverage." This, he says, "will discourage banks from getting so big" and "that's fine. That's what we want to do."

Mr. Becker is underwhelmed by the stimulus package: "Much of it doesn't have any short-term stimulus. If you raise research and development, I don't see how it's going to short-run stimulate the economy. You don't have excess unemployed labor in the scientific community, in the research community, or in the wind power creation community, or in the health sector. So I don't see that this will stimulate the economy, but it will raise the debt and lead to inefficient spending and a lot of problems."

There is also the more fundamental question of whether one dollar of government spending can produce one and a half dollars of economic output, as the administration claims. Mr. Becker is more than skeptical. "Keynesianism was out of fashion for so long that we stopped investigating variables the Keynesians would look at such as the multiplier, and there is almost no evidence on what the multiplier would be." He thinks that the paper by Christina Romer, chairman of the Council of Economic Advisors, "saying that the multiplier is about one and a half [is] based on very weak, even nonexistent evidence." His guess? "I think it is a lot less than one. It gets higher in recessions and depressions so it's above zero now but significantly below one. I don't have a number, I haven't estimated it, but I think it would be well below one, let me put it that way."

As the interview winds down, I'm thinking more about how people can make pretty crazy decisions with the right incentives from government. Does this explain what seems to be a decreasing amount of personal responsibility in our culture? "When you get a larger government, when you have the government taking over Social Security, government taking over health care and with further proposals now for the government to take over more activities, more entitlements, the rational response is to have less responsibility. You don't have to worry about things and plan on your own as much."

That suggests that there is a risk to the U.S. system with more people relying on entitlements. "Well, they become an interest group," Mr. Becker says. "The more you have dependence on the government, the stronger the interest group of people who want to maintain it. That's one reason why it is so hard to get any major reform in reducing government spending in Scandinavia and it is increasingly so in the United States. The government is spending -- at the federal, state and local level -- a third of GDP, and that share will go up now. The higher it is the more people who are directly or indirectly dependent on the government. I am worried about that. The basic theory of interest-group politics says that they will have more influence and their influence will be to try to maintain this, and it will be hard to go back."

Still, there remain many good reasons to continue the struggle against the current trend, Mr. Becker says. "When the market economy is compared to alternatives, nothing is better at raising productivity, reducing poverty, improving health and integrating the people of the world."

Greg Mankiw reports that the yield curve is steep, meaning that long-term interest rates have risen. In my view, this is perfectly rational, and it shows that the short-run effect of the fiscal stimulus is negative, as Jeff Sachs predicted.

This is all based on a Keynesian type of macro analysis. As we know, most of the stimulus spending does not take place until next year and beyond, so the short-run gains are puny. On the other hand, the big increase in the projected deficit creates the expectation of higher interest rates, which raises interest rates now. These higher interest rates serve to weaken the economy.

According to this standard analysis, the stimulus is going to hurt GDP now, when we could use the most help. Much of the spending will kick in a year or more from now, with multiplier effects following afterward, when the economy will need little, if any, stimulus.

This is the flaw with using spending rather than tax cuts as a stimulus. The lags are longer when you use spending.

Of course, if the real goal is to promote government at the expense of civil society and to create a one-party state in which business success is based on political favoritism, then the stimulus is working exactly as intended.

[UPDATE] It is important not to confuse the outlook for economic activity with the effect of the stimulus. Even if the stimulus has a negative impact, the outlook for economic activity could be positive, and this could cause an upward-sloping yield curve. But I'm not sure that the outlook is necessarily positive. Bond investors could simply be taking the view that with or without a strong recovery in real output, the deficit spending is going to be monetized at some point, leading to inflation and higher interest rates.

The federal government is trying to strengthen the U.S. auto industry. So here's a great idea for what it can do: Tell the Big Three to raise their prices across the board.

That would help in some obvious ways. Higher prices would mean bigger profit margins on every sale. Bigger profits would mean more jobs. More jobs would mean more workers buying new American cars.

But anyone can see that raising prices wouldn't work, because it would dry up sales. If American consumers were willing to pay more for American cars, dealers would already be charging higher prices. This is such an obviously boneheaded idea that no one would ever dream of doing it.

But in the realm of employee compensation, the federal government is taking that absurd notion and putting it into law. Come Friday, the federally mandated minimum wage will jump from $6.55 an hour to $7.25—an 11 percent increase. At a time when employers are laying off workers, Washington is going to make it more expensive to keep them.

If you're a minimum wage employee, your job will pay more, but only if it still exists. These days, most companies are scrutinizing every position on the payroll to make sure it's worth the cost. Raise the toll, and some employees will find they are no longer valuable enough to make the cut.

Economists generally agree that increases in the minimum wage cause unemployment even when the economy is prospering—something it has not been doing for the last year and a half. David Neumark, a professor at the University of California, Irvine, estimates this rise will destroy some 300,000 jobs among teens and young adults.

Even proponents of the increase understand the tradeoff. Otherwise they would demand an even bigger hike. If you can force employers to pay higher wages without reducing employment, why set the minimum at $7.25 an hour? Why not $17.25? Why not $37.25?

The suspension of disbelief required to support the minimum wage will only take you so far. It's impossible to deny that if it were illegal to pay someone less than a mere $36 an hour, a lot of jobs would vanish. But a small dose of poison is still poison, and in this case it's being administered to a patient who is already ill.

Supporters make a virtue of bad timing by claiming the change will provide a stimulus exactly when the economy needs it. The liberal Economic Policy Institute in Washington insists that a minimum wage increase "would not only benefit low-income working families, but it would also provide a boost to consumer spending and the broader economy."

Not likely. Companies, unlike the government, can't create cash at will. Any money they give to workers has to be obtained by cutting jobs, reducing employee benefits, or slashing other expenses that happen to be someone's income. Net stimulus: zero.

Besides eliminating minimum wage jobs, the increase stands to have another little-noticed effect: pushing people into jobs that pay even less. Some employees are exempt from the law, including those working in newspaper delivery, fishing, and seasonal amusement parks, as well as staffers at companies with annual revenues of less than $500,000 a year.

Doesn't sound like a big group, does it? But in 2008, reports the Bureau of Labor Statistics, 1.94 million Americans were below the "minimum" wage—compared to 286,000 getting the actual minimum. When the floor went unchanged for 10 years, the number of workers in sub-minimum jobs steadily declined. But in 2007, when the mandate went from $5.15 to $5.85, the total climbed by 14 percent, at a time when overall employment was stable.

That's not a coincidence. Economist Alan Reynolds of the libertarian Cato Institute in Washington has found that when the minimum wage went up in 1996 and 1997, the number of workers beneath the floor expanded by more than 75 percent—even though the economy was booming. It looks like the minimum wage destroys some low-paying jobs and replaces them with lower-paying ones, to the detriment of the people who are supposed to benefit.

Economics punctures alluring myths about the sources of material improvement, which is why it is known as the "dismal science." But the victims of the minimum wage will find that the truly dismal thing about economics is what happens when you ignore it.

A long winded and often pedantic piece about the causes of recessions and the upswings that follow. I've only included the conclusion; see the rest of the piece for the long-winded Austrian take:

Most experts are of the view that the worst of the US recession may be over by year's end. Common opinion holds that the key reason for the expected turnaround is the positive effect that the policies of the government and Fed have on various economic indicators. The pace of monetary pumping by the US central bank jumped from 4% in September 2007 to 152% by December 2008. With respect to fiscal stimulus, aggressive government spending has resulted in a record deficit of over one trillion dollars in the first nine months of fiscal year 2009. Careful examination shows that, rather than protecting the economy, it is loose monetary policies that are the key source of boom-bust economic cycles. Loose Fed and government fiscal policies have only weakened the wealth generators' ability to grow the economy. Aggressive policies have inflicted severe damage to the sources of funding that support real economic growth. Hence, we are doubtful that the US economy is on the verge of a solid economic recovery. On account of massive monetary pumping, the growth in momentum of various key economic data is likely to strengthen in the months ahead. We maintain this may prompt Fed policy makers to consider curtailing the pace of monetary pumping, and we suggest that this will set in motion a new economic bust.

As covered in both today’s Wall Street Journal and Washington Post, the Obama administration has called 25 of the largest mortgage servicing companies to Washington to try to figure out why the Obama efforts to stem foreclosures has been a failure.

The reason such efforts, as well as those of the Bush Administration and the FDIC, have been a failure is that such efforts have grossly misdiagnosed the causes of mortgage defaults. An implicit assumption behind former Treasury Secretary Paulson’s HOPE NOW, FDIC Chair Sheila Bair’s IndyMac model, and the Obama Administration’s current foreclosure efforts is that the current wave of foreclosures is almost exclusively the result of predatory lending practices and “exploding” adjustable rate mortgages, where large payment shocks upon the rate re-set cause mortgage payment to become “unaffordable.”

The simple truth is that the vast majority of mortgage defaults are being driven by the same factors that have always driven mortgage defaults: generally a negative equity position on the part of the homeowner coupled with a life event that results in a substantial shock to their income, most often a job loss or reduction in earnings. Until both of these components, negative equity and a negative income shock are addressed, foreclosures will remain at highly elevated levels.

Sadly the Obama Administration is likely to use today’s meeting as simply an excuse to deflect blame from themselves onto “greedy” lenders. Instead the Administration should be focusing on avenues for increasing employment and getting our economy growing again. Then of course, this Administration has from the start been more focused on re-distributing wealth rather than creating it, which explains why it views mortgage modifications as simply a game of taking from lenders (in reality investors - like pension funds) and giving to delinquent homeowners.

Perhaps too eclectic a piece for this category, but I was struck by some of the economic arguments made herein.

Tuesday, July 28, 2009

[Ilya Somin, July 28, 2009 at 8:24pm] TrackbacksDo the Recent Failures of the Oakland A's Discredit Moneyball Strategies in Baseball and Academia? Like many academics, I have praised the "Moneyball" strategies adopted by Oakland A's GM Billy Beane. Beane's innovative use of statistical methods for evaluating player performance built the small-market A's into a powerhouse that posted records as good as those of top teams with much higher payrolls, including the Red Sox and Yankees. Meanwhile, in the academic world, my employer, the George Mason University School of Law, used similar strategies to identify and hire undervalued scholars, an approach that enabled the school to rise rapidly in the US News rankings (from around 90th or so in the late 90s, to a peak of 34th in 2007 and 41st today). GMU's moneyball approach also enjoyed impressive successes on measures of faculty quality, such as Brian Leiter's citation count study, in which we ranked 21st in 2007. Like the A's, GMU has outperformed competitors with much greater financial resources (we charge lower tuition and have a much smaller endowment than most of our peer schools).However, as ESPN writer Howard Bryant explains in this article, the A's poor performance over the last three years has led many people to doubt the effectiveness of Beane's approach. Although GMU's rankings haven't fallen anywhere near as much as the A's place in the American League standings, we have fallen a few slots in US News over the last two years.

In my view, the the A's recent problems in no way discredit Moneyball strategies. In both baseball and academia, Moneyball hiring is still a success. And, while the A's may not have a bright future, I am cautiously optimistic that GMU does.

I. The A's Problems are Caused by Moneyball's Success.

As Daniel Drezner explains, the A's have slipped not because Moneyball strategies stopped working, but because other teams with bigger payrolls (most notably, my beloved Red Sox) successfully copied them. So long as the A's were the only ones rigorously applying Moneyball strategies, they could outperform bigger-spending rivals with inferior approaches. But once the Red Sox and other larger market teams copied the A's approach, it got much harder for Beane to keep up. If the A's were defeated by clubs relying on pre-Moneyball conventional wisdom, that would indeed discredit their approach. Being defeated by better-heeled imitators actually vindicates it.

Furthermore, Beane's overall record as GM is still very impressive. Since he took over in 1999, the A's have made five playoff appearances and had two other seasons when they won around 90 games and just missed the postseason. I hate to admit it, but this is almost as good as the Red Sox' record over the same period (6 playoff appearances and one other 90 win season) - and the Red Sox spent more than twice as much as the A's on payroll during that time. The Red Sox of the last ten years are usually considered one of the best-run teams in baseball. Had Beane been given as much money to play with as Boston's GMs, the A's would probably have been a lot better than the Sox - or any other AL franchise.

II. Implications for GMU and Legal Academia.

Nonetheless, the recent decline of the A's does raise the question of whether GMU will suffer a similar decline as better-funded competitors mimic some of our hiring strategies. It certainly could happen, but I am guardedly optimistic that it won't. Competitive pressure in academia is much weaker than in professional sports, where losing GMs tend to get fired and owners of losing teams suffer big financial losses. In the academic world, faculty who perform poorly relative to their competitors are unlikely to lose either funding or tenure. Even law school deans are unlikely to lose their jobs merely because the school's ranking stagnates or declines.

Thus, GMU's innovations are less likely to be copied widely than those of the A's. Even so, some have spread. The three undervalued faculty assets that GMU has historically pursued include 1) law and economics scholars, 2) conservative and libertarian academics who might have gone to higher-ranked schools but for ideological discrimination, and 3) academics with strong publication records who were overlooked by higher-ranked schools because they didn't have a prestigious clerkship or didn't get their JDs at a top-5 school. I think it's clear that law and econ scholars are no longer undervalued by most of our competitors. Ideological discrimination and school/clerkship snobbery persist, but both are less intense than ten years ago. In particular, our rivals are beginning to realize that past publication record is a better predictor of the quality of future scholarship than who you clerked for or where you got your JD (this is similar to Beane's famous insistence on evaluating prospects based on minor league and college stats rather than whether they looked good to tradition-minded scouts).

Overall, one of our comparative advantages has been completely eliminated by the market, and the other two have at least been eroded. On the other hand, we have several edges that the A's don't. Unlike the A's, we can close the financial gap that separates us from our rivals by building up our endowment over time (the A's resources, by contrast, are constrained by their status as a small-market team). The school's rise in the rankings and increased public profile make fundraising easier. Converting a temporary innovative edge into longterm financial success is much easier in academia than baseball.

In addition, ideological discrimination and school/clerkship snobbery are likely to persist to a significant degree. We can therefore continue to exploit these two shortcomings of many of our peer schools. Finally, GMU has an important advantage stemming from its geographic location near Washington, DC - an attractive site for people interested in law, history, and public policy. I doubt that GMU will rise as fast in the rankings over the next ten years as it did over the last ten. But if we continue to follow good hiring strategies, we should be able to hold on to our gains and hopefully make some additional progress.

UPDATE: I do not wish to suggest that US News rankings are anywhere close to perfect indicators of a law school's relative quality. Like many other academics, I have criticized them in the past. However, rising 50 slots in the rankings, as GMU did, is probably an indicator of significant progress. In addition, GMU actually does better on more objective measures of faculty quality, such as Leiter's citation counts (where we are close to the top 20), and SSRN download counts (where we rank 18th over the last year, and 11th if one controls for the relatively small size of our faculty).

MOODY'S Economy.com has mapped the geographic spread of the worst global downturn since the Depression. All of North America is in recession now. In Europe only Norway, Slovenia and Slovakia have avoided a similar fate, although Moody’s reckons these countries are on the brink of a downturn. Emerging Asia looks cheerier, although the small export-led economies of Singapore and Hong Kong are shrinking, as are Malaysia and Thailand. Even the BRICs are looking a bit diminished, with downturns in both Brazil and Russia. At least India and China are growing (the latter at a pace that is causing worries about overheating). Data for Africa are spotty but the continent’s biggest economy, South Africa, is in recession. The IMF expects global GDP to shrink by 1.4% this year, with rich countries’ economies contracting by around 3.8%.

"Buried within the October 3, 2008 bailout bill was a provision permitting the Fed to pay interest on bank reserves. Within days, the Fed implemented this new power, essentially converting bank reserves into more government debt. Now, any seigniorage that government gains from creating bank reserves will completely vanish or be greatly reduced."

Almost everyone is aware that federal government spending in the United States is scheduled to skyrocket, primarily because of Social Security, Medicare, and Medicaid. Recent "stimulus" packages have accelerated the process. Only the naively optimistic actually believe that politicians will fully resolve this looming fiscal crisis with some judicious combination of tax hikes and program cuts. Many predict that, instead, the government will inflate its way out of this future bind, using Federal Reserve monetary expansion to fill the shortfall between outlays and receipts. But I believe, in contrast, that it is far more likely that the United States will be driven to an outright default on Treasury securities, openly reneging on the interest due on its formal debt and probably repudiating part of the principal.

To understand why, we must look at U.S. fiscal history. Economists refer to the revenue that government or its central bank generates through monetary expansion as seigniorage. Outside of America's two hyperinflations (during the Revolution and under the Confederacy during the Civil War), seigniorage in this country peaked during World War II, when it covered nearly a quarter of the war's cost and amounted to about 12 percent of Gross Domestic Product (GDP). By the Great Inflation of the 1970s, seigniorage was below two percent of federal expenditures or less than half a percent of GDP.1 This was partly a result of globalization, in which international competition disciplines central banks. And it also was the result of sophisticated financial systems, with fractional reserve banking, in which most of the money that people actually hold is created privately, by banks and other financial institutions, rather than by government. Consider how little of your own cash balances are in the form of government-issued Federal Reserve notes and Treasury coin, rather than in the form of privately created bank deposits and money market funds. Privately created money, even when its quantity expands, provides no income to government. Consequently, seigniorage has become a trivial source of revenue, not just in the United States, but also throughout the developed world. Only in poor countries, such as Zimbabwe, with their primitive financial sectors, does inflation remain lucrative for governments.

For more on hyperinflations, bank reserves, and central banks, see Hyperinflation, Money Supply, and Federal Reserve System in the Concise Encylopedia of Economics.

The current financial crisis, moreover, has reinforced the trend toward lower seigniorage. Buried within the October 3, 2008 bailout bill, which set up the Troubled Asset Relief Program (TARP), was a provision permitting the Fed to pay interest on bank reserves, something other major central banks were doing already. Within days, the Fed implemented this new power, essentially converting bank reserves into more government debt. Fiat money traditionally pays no interest and, therefore, allows the government to purchase real resources without incurring any future tax liability. Federal Reserve notes will, of course, continue to earn no interest. But now, any seigniorage that government gains from creating bank reserves will completely vanish or be greatly reduced, depending entirely on the differential between market interest rates on the remaining government debt and the interest rate on reserves. The lower is this differential, the less will be the seigniorage. Indeed, this new constraint on seigniorage becomes tighter as people replace the use of currency with bank debit cards and other forms of electronic fund transfers. In light of all these factors, even inflation well into the double digits can do little to alleviate the U.S. government's potential bankruptcy.

What about increasing the proceeds from explicit taxes? Examine Graph 1, which depicts both federal outlays and receipts as a percent of GDP from 1940 to 2008. Two things stand out. First is the striking behavior of federal tax revenue since the Korean War. Displaying less volatility than expenditures, it has bumped up against 20 percent of GDP for well over half a century. That is quite an astonishing statistic when you think about all the changes in the tax code over the intervening years. Tax rates go up, tax rates go down, and the total bite out of the economy remains relatively constant. This suggests that 20 percent is some kind of structural-political limit for federal taxes in the United States. It also means that variations in the deficit resulted mainly from changes in spending rather than from changes in taxes. The second fact that stands out in the graph is that federal tax revenue at the height of World War II never quite reached 24 percent of GDP. That represents the all-time high in U.S. history, should even the 20-percent-of-GDP post-war barrier prove breachable.2

Graph 1. Federal Outlays and Receipts as a Percent of GDP, 1940-2008

Compare these percentages with that of President Barack Obama's first budget, which is slated to come in at above 28 percent of GDP. Although this spending surge is supposed to be significantly reversed when the recession is over, the administration's own estimates have federal outlays never falling below 22 percent of GDP. And that is before the Social Security and Medicare increases really kick in. In its latest long-term budget scenarios, the Congressional Budget Office (CBO), not known for undue pessimism, projects that total federal spending will rise over the next 75 years to as much as 35 percent of GDP, not counting any interest on the accumulating debt, which critically varies with how fast tax revenues rise. However, the CBO's highest projection for tax revenue over the same span reaches a mere 26 percent of GDP. Notice how even that "optimistic" projection assumes that Americans will put up with, on a regular peacetime basis, a higher level of federal taxation than they briefly endured during the widely perceived national emergency of the Second World War. Moreover, once you add in the interest on the growing debt because of the persistent deficits, federal expenditures in 2083, according to the CBO, could range anywhere between 44 and 75 percent of GDP.3

We all know that there is a limit to how much debt an individual or institution can pile on if future income is rigidly fixed. We have seen why federal tax revenues are probably capped between 20 and 25 percent of GDP; reliance on seigniorage is no longer a viable option; and public-choice dynamics tell us that politicians have almost no incentive to rein in Social Security, Medicare, and Medicaid. The prospects are, therefore, sobering. Although many governments around the world have experienced sovereign defaults, U.S. Treasury securities have long been considered risk-free. That may be changing already. Prominent economists have starting considering a possible Treasury default, while the business-news media and investment rating agencies have begun openly discussing a potential risk premium on the interest rate that the U.S. government pays. The CBO estimates that the total U.S. national debt will approach 100 percent of GDP within ten years, and when Japan's national debt exceeded that level, the ratings of its government securities were downgraded.

The much (unfairly) maligned credit default swaps (CDS) in February 2009 were charging more for insurance against a default on U.S. Treasuries than for insurance against default of such major U.S. corporations as Pepsico, IBM, and McDonald's. Because the premiums and payoffs of the CDS on U.S. Treasury securities are denominated in Euros, the annual premiums also reflect exchange-rate risk, which is probably why, with the subsequent modest decline in the dollar, CDS premiums for ten-year Treasuries fell from 100 basis points to almost 30.4 But you can make a plausible case that CDS underestimate the probability of a Treasury default since such a default could easily have far reaching financial repercussions, even hurting the counterparties providing the insurance and impinging on their ability to make good on their CDS. Surely the purchasers of the U.S. Treasury CDS have not overlooked this risk, which would be reflected in a lower annual premium for less-valuable insurance.

Predicting an ultimate Treasury default is somewhat empty unless I can also say something about its timing. The financial structure of the U.S. government currently has two nominal firewalls. The first, between Treasury debt and unfunded liabilities, is provided by the trust funds of Social Security, Medicare, and other, smaller federal insurance programs. These give investors the illusion that the shaky fiscal status of social insurance has no direct effect on the government's formal debt. But according to the latest intermediate projections of the trustees, the Hospital Insurance (HI-Medicare Part A) trust fund will be out of money in 2017, whereas the Social Security (OASDI) trust funds will be empty by 2037.5 Although other parts of Medicare are already funded from general revenues, when HI and OASDI need to dip into general revenues, the first firewall is gone. If investors respond by requiring a risk premium on Treasuries, the unwinding could move very fast, much like the sudden collapse of the Soviet Union. Politicians will be unable to react. Obviously, this scenario is pure speculation, but I believe it offers some insight into the potential time frame.

The second financial firewall is between U.S. currency and government debt. It is not literally impossible that the Federal Reserve could unleash the Zimbabwe option and repudiate the national debt indirectly through hyperinflation, rather than have the Treasury repudiate it directly. But my guess is that, faced with the alternatives of seeing both the dollar and the debt become worthless or defaulting on the debt while saving the dollar, the U.S. government will choose the latter. Treasury securities are second-order claims to central-bank-issued dollars. Although both may be ultimately backed by the power of taxation, that in no way prevents government from discriminating between the priority of the claims. After the American Revolution, the United States repudiated its paper money and yet successfully honored its debt (in gold). It is true that fiat money, as opposed to a gold standard, makes it harder to separate the fate of a government's money from that of its debt. But Russia in 1998 is just one recent example of a government choosing partial debt repudiation over a complete collapse of its fiat currency.

Admittedly, seigniorage is not the only way governments have benefited from inflation. Inflation also erodes the real value of government debt, and if the inflation is not fully anticipated, the interest the government pays will not fully compensate for the erosion. This happened during the Great Inflation of the 1970s, when investors in long-term Treasury securities earned negative real rates of return, generating for the government maybe one percent of GDP, or about twice as much implicit revenue as came from seigniorage. But today's investors are far savvier and less likely to get caught off guard by anything less than hyperinflation. To be clear, I am not denying that a Treasury default might be accompanied by some inflation. Inflationary expectations, along with the fact that part of the monetary base is now de facto government debt, can link the fates of government debt and government money. This is all the more reason for the United States to try to break the link and maintain the second financial firewall. We still may end up with the worst of both worlds: outright Treasury default coupled with serious inflation. I am simply denying that such inflation will forestall default.

Still unconvinced that the Treasury will default? The Zimbabwe option illustrates that other potential outcomes, however unlikely, are equally unprecedented and dramatic. We cannot utterly rule out, for instance, the possibility that the U.S. Congress might repudiate a major portion of promised benefits rather than its debt. If it simply abolished Medicare outright, the unfunded liability of Social Security would become tractable. Indeed, one of the current arguments for the adoption of nationalized health care is that it can reduce Medicare costs. But this argument is based on looking at other welfare States such as Great Britain, where government-provided health care was rationed from the outset rather than subsidized with Medicare. Rationing can indeed drive down health-care costs, but after more than forty years of subsidized health care in the United States, how likely is it that the public will put up with severe rationing or that the politicians will attempt to impose it? And don't kid yourself; the rationing will have to be quite severe to stave off a future fiscal crisis.

Other welfare States have higher taxes as a proportion of GDP, with Sweden and Denmark in the lead at nearly 50 percent.6 Can I really be confident that the United States will never follow their example? Let us ignore all the cultural, political, and economic differences between small, ethnically-unified European States and the United States. We still must factor in the take of state and local governments, which, together with the federal government, raises the current tax bite in the United States to 28 percent of GDP, only five percentage points below that of Canada. Recall that the CBO projects that federal spending alone for 2082 will reach almost 35 percent of GDP, excluding rising interest on the national debt. Thus, if taxes were to rise pari passu with spending, the United States might be able to forestall bankruptcy with a total tax burden, counting federal, state, and local, of around 45 percent of GDP—15 percentage points higher than the combined total at its World War II peak, higher than in the United Kingdom and Germany today, and nearly dead even with Norway and France. However, if there is any significant lag between expenditure and tax increases, the increased debt would cause the proportion to rise even more. Furthermore, this estimate relies on the CBO's economic and demographic assumptions about the future, along with the assumption of absolutely no increase in state and local taxation as a percent of GDP. More-pessimistic assumptions also drive the percentage up.

Even conceding that federal taxes might rise rapidly enough to a level noticeably higher than during World War II overlooks an important consideration: All the social democracies are facing similar fiscal dilemmas at almost the same time. Pay-as-you go social insurance is just not sustainable over the long run, despite the higher tax rates in other welfare States. Even though the United States initiated social insurance later than most of these other welfare States, it has caught up with them because of the Medicare subsidy. In other words, the social-democratic welfare State will come to end, just as the socialist State came to an end. Socialism was doomed by the calculation problem identified by Ludwig Mises and Friedrich Hayek. Mises also argued that the mixed economy was unstable and that the dynamics of intervention would inevitably drive it towards socialism or laissez faire. But in this case, he was mistaken; a century of experience has taught us that the client-oriented, power-broker State is the gravity well toward which public choice drives both command and market economies. What will ultimately kill the welfare State is that its centerpiece, government-provided social insurance, is simultaneously above reproach and beyond salvation. Fully-funded systems could have survived, but politicians had little incentive to enact them, and much less incentive to impose the huge costs of converting from pay-as-you-go. Whether this inevitable collapse of social democracies will ultimately be a good or bad thing depends on what replaces them.

Footnotes1.Gary M. Walton and Hugh Rockoff, History of the American Economy, 10th ed. (Mason, OH: South-Western, 2005), p. 500; Robert Higgs, "The World Wars," in Price Fishback, et. al., History of the American Government and Economy: Essays in Honor of Robert Higgs (Chicago: University of Chicago Press, 2007); Jeffrey Rogers Hummel, "Death and Taxes, Including Inflation: The Public versus Economists," Econ Journal Watch, 4 (January 2007): 46-59.

2.Data on government expenditures and revenues come from Susan B. Carter, et. al., eds., Historical Statistics of the United States: Earliest Times to the Present, Millennial ed. (New York: Cambridge University Press, 2006), v. 5, Series Ea584-678, as brought forward by Budget of the United States Government: Historical Tables Fiscal Year 2010 (Washington: U.S. Government Printing Office, 2009). Annual estimates for GDP are from Louis D. Johnston and Samuel H. Williamson, "What Was the U.S. GDP Then?" MeasuringWorth, 2008. Their GDP numbers coincide with those of the U.S. Bureau of Economic Analysis.

*Jeffrey Rogers Hummel is Associate Professor of economics at San Jose State University and the author of Emancipating Slaves, Enslaving Free Men: A History of the American Civil War. Some of his more recent writings can be found on the Liberty & Power group blog.

Hmm, models longer in development fail to explain phenomena occurring in systems less complex than say the planetary climate. Could a lesson lie within?

Guy SormanWild RandomnessTraditional economics has failed to grasp the complexity and dynamism of financial markets.Summer 2009

In the summer of 2008, wheat and corn prices shot up across the globe. Pundits provided seemingly convincing explanations: grain was becoming scarce and thus more expensive because mainland Chinese were changing their eating habits and needed lots of it to feed their cattle—or perhaps because fear of oil shortages, combined with ecological fads, was leading consumers to adopt corn-based ethanol. Yet one year later, the Chinese are eating basically the same food as last year (feeding habits change very slowly), ethanol production is more or less at the same level, but the price of grain and corn on the Chicago market is back down again. How to explain the volatility of prices when production levels remain essentially the same?

The reason: grain or corn prices may at any point in time be driven more by speculation than by actual harvests. The rule applies to all transactions on financial markets, including oil, stocks, and derivatives. This is one of many examples that Rama Cont offers to describe how the real economy and the financial markets follow different rationales. In the short term—which can mean several years, in practice—the connection can be tenuous at best and difficult to model. If the connection were closer, Cont would know: he is at the forefront of the new science of financial modeling.

Finance itself is a relatively young field of research in which data have been available in large quantities only over the last 20 years. Thanks to electronic trading, it is now possible to quantify and analyze the fluctuations of financial markets on a large scale, but much interdisciplinary expertise is necessary to make headway in understanding it all.

In fact, Cont, an associate professor at Columbia University, conducts his research not in the economics department but in the School of Engineering and Applied Science. “My background is in theoretical physics,” he tells me. He discovered economics by accident while studying in Paris, where he emigrated from Tehran in 1987. “When I first became interested in economics, I was surprised by the deductive, rather than inductive, approach of many economists,” he says. Whereas in physics, researchers tend to observe empirical data and then build a theory to explain their observations, “many economic studies typically start with a theory and eventually attempt to fit the data to their model.” Such an approach might have been justifiable when financial and economic data were scarce, he believes, but with today’s wealth of information it is no longer acceptable.

Traditional economics, Cont argues, has failed to grasp the complexity and dynamic nature of financial markets. This outlook leads him to a distinctive interpretation of the current financial crisis. While the mainstream view explains the crisis by a lack of regulation, Cont believes that misguided regulations, often applied by not-too-smart regulators, were also a major factor. “Bear Stearns was perfectly compliant with regulations on the eve of its bankruptcy,” he observes. It had strictly followed the international banking rules imposed by the so-called Basel II Convention and, in fact, held $2 billion in excess of the amount of capital that the convention required for the bank to weather a major shock. But that capital, the regulations say, can consist of assets, such as bonds or shares, that aren’t liquid—that is, they have a market value but aren’t cash. In a panic situation, a bank needs cash to pay its creditors, and when confronted about its debts, Bear Stearns had only illiquid assets and no time to sell them. The bank went under the next day. The regulation seemed cleverly designed, Cont says, but proved useless in a real-life situation.

Why did the demise of Lehman Brothers generate worldwide financial turmoil? Again, Cont believes, existing regulations were at fault. As Lehman liquidated its portfolio, he explains, it sold off large quantities of stock, pushing overall stock prices down. This resulted in losses for other banks and increased the risk of their portfolios. To comply with Basel II regulations, these banks then had to reduce that risk by cutting back lending and by selling assets. They did both, bringing the stock exchange to its knees and drying up global credit.

Does Cont’s indictment of poorly designed regulations mean that he holds Wall Street bankers blameless? No: the bankers were greedy, he charges—though “greed in itself is not a new phenomenon.” But the Wall Street bonus system, as everyone knows by now, institutionalized that greed by compensating high short-term returns, so that traders and managers had an incentive to take more—and more dangerous—risks. That risk-taking, Cont says, should have been balanced by countervailing forces, such as boards of directors that, in theory, would represent the long-term interests of the banks and their shareholders. But Wall Street bank boards tended to have little say in the day-to-day management of the companies.

Nor did other countervailing forces intercede. Every bank had a risk-management unit, Cont points out, but the risk manager usually wasn’t a major figure, and the quantitative analysts in the risk units typically had little influence on major bank decisions. “Everybody knows the names of the CEOs of major investment banks,” he says. “But who has ever heard of the Chief Risk Officer of these institutions?”

Less sophisticated investors—fund managers and sovereign funds—relied on rating agencies for guidance, but didn’t get good advice, to say the least. The agencies—Moody’s, Standard and Poor’s, Fitch—utterly failed to anticipate the huge risks in the subprime market. “Either they truly ignored the risk of a fall in the housing market or they pretended everything was fine, in order to sustain the bubble and profit from it while it lasted,” says Cont. Ignorance probably played the larger role, he thinks. Rating agencies, like investors and regulators, rely on relatively simple models to forecast the risk associated with future market movements. Those models often assume a “mild randomness” of market fluctuations. In reality, Cont argues, what visionary mathematician Benoît Mandelbrot calls “wild randomness” prevails: risk is concentrated in a few rare, hard-to-predict, but extreme, market events (see sidebar).

Simple forecasts can also be mistaken if they fail to account for the actions of market participants themselves: investor strategies can influence prices, which in turn influence future strategies in a feedback loop that can cause considerable instability. Cont recalls the severe stock-market crash of October 1987, which seemed to strike out of the blue, since nothing significant was happening in the real economy. Subsequent research, though, blamed the crash in part on a new investment strategy, “portfolio insurance,” which a large number of fund managers had simultaneously adopted. Based on the famous Black-Scholes options-pricing model, this strategy recommended that fund managers reduce their risks by automatically selling shares whenever their values fell. But the approach didn’t take into account what would happen if many investors followed it simultaneously: a massive sell-off that could send the market plummeting. The 1987 crash was thus not provoked by events in the real economy but by a supposedly smart risk-management strategy—and the current downturn, of course, also derives at least partly from a global craze for a seemingly foolproof financial innovation.

Yet if the financial markets can become disconnected from the real economy and then generate storms that threaten and damage prosperity, Cont continues, they are nevertheless essential to a flourishing economy. They have dragged us under now; but over the last several decades, they have helped drive unprecedented global growth and innovation.

Investors in financial markets rationally pursuing individual profit, then, can produce outcomes that are globally negative. Doesn’t that contradict classical economic theory? “Both theory and empirical facts do tend to show that, on the financial markets, the Invisible Hand does not always lead to welfare-improving general outcomes,” Cont replies.

He offers another example: the diversification strategies that any wise investor should follow to protect himself from market risk. In the 1990s, in the name of diversification, investors poured money into various emerging markets and did well. When a currency crisis hit some Asian countries in 1997, however, emerging-market funds had to sell off Brazilian assets to dampen their losses on Asian investments, causing a sharp fall in Brazilian stocks. Rational individual choices in the financial markets had amplified a local shock in Asia into a systemic shock felt across the globe.

Is there a way to protect against these disruptions? “To regulate a financial market efficiently, we need first to understand its mechanisms,” Cont argues. Knowledge is thus the priority. Currently, regulatory bodies like the Federal Reserve and the SEC can determine the risk exposure of financial institutions, but only at a national level. The market, however, is global, and at present, we have no monitor to assess risk factors and their interdependence at the global level.

A first step toward rectifying this problem, Cont believes, would be to create a global risk observatory. In previous global crashes, abnormal concentrations of market participants began to engage in similar investment strategies—portfolio insurance back in the eighties and leveraged housing loans more recently. A global risk observatory would be in a position to observe such concentrations and raise a red flag. It would then be up to each national regulator to take these alerts into consideration or dismiss them. Cont doesn’t go so far as to promote the idea of an international regulator, which would potentially conflict with national sovereignty. In any case, the United States has already said that it would not accept such a body. An observatory is feasible, however: the data exist and need only be consolidated.

As for national regulators, Cont maintains that they should focus on ensuring financial stability and protecting against systemic risk, rather than worry about the health of individual financial institutions. Rules that apparently help reduce risk in individual firms can sometimes amplify systemwide risk, as with the Basel II regulations that required banks to reduce lending and sell assets after Lehman’s fall. Further, national regulation should encompass not only banks but all institutions, such as insurance companies and mortgage brokers, that have an impact on the financial system.

If realized, Cont’s proposals would not stabilize the financial markets overnight. But they could help us avoid the kind of regulations that tend to aggravate crises. His proposals may also seem modest, given the scope of the current crisis. “The American public is fond of gurus,” he says—and he isn’t one. He is only a man of science.

Guy Sorman, a City Journal contributing editor, is the author of numerous books, including the brand-new Economics Does Not Lie.

The Mandelbrot Line

At 86, creative and witty as ever, Benoît Mandelbrot has grown accustomed to the ups and downs of his scientific reputation. When the Dow Jones touches the sky, economists tend to forget his dark prophecies; when crisis strikes, he is suddenly rediscovered. These days, at his Cambridge apartment overlooking the Charles River, he gets more calls than ever. The last time publishers and conference organizers besieged him with so many requests was in 2000, after the Internet bubble burst—and before that, in 1987, when the stock market unexpectedly crashed. At the time, Mandelbrot seemed to be the only thinker able to explain why crashes could happen without any apparent economic reason. Financial markets, he argued, follow their own internal logic, not necessarily related to actual economic factors.

Mandelbrot has many disciples. Rama Cont, in the field of financial modeling, is one of the most noteworthy. The notion of “black swans”—unpredictable, rare, and massive-impact events—has made the trader and author Nassim Taleb famous, and it is pure Mandelbrot. George Soros’s apocalyptic economic scenarios derive from Mandelbrot, too, though haphazardly quoted.

Mandelbrot does not define himself primarily as an economist: he is, above all, a mathematician. Born in Poland, educated in France, a professor at Harvard in the 1960s and at Yale in the 1990s, with 30 years in between at IBM’s research center in Yorktown Heights, New York, the man is as unconventional as his career. In 1974, he became an instant celebrity with his theory of fractals—a fractal being “a rough or fragmented geometric shape that can be split into parts, each of which is (at least approximately) a reduced-size copy of the whole,” as he once defined it. On college campuses, T-shirts soon appeared adorned with fractal figures, which often appear in nature: think of snowflakes.

While most scientists try to understand and describe what is regular, repetitive, and hence predictable in nature, Mandelbrot mostly interests himself in the accidental, what he calls “monsters.” The fractal mathematics that he invented lets us see the hidden rules of apparent disorder, the order behind monstrous chaos. But can we deduce from the idea of fractals that any seemingly chaotic occurrence—like prices on the stock exchange—can be anticipated? Many financial economists think so and have tried to use mathematical formulas to master market volatility.

Mandelbrot dismisses these economists as hubristic and notes that all of their predictive theories have proved false. They commit two scientific errors, he says. First, they try to transport the theory of fractals into a field where it does not apply. (This is a common temptation—recall Marx, who tried to apply the laws of thermodynamics and Darwinian evolution to history and the social sciences.) Second, they do not start from the empirical data but instead build a curve first, assuming a logic behind volatility. When stock prices are shooting upward, these economists win media praise and even Nobel Prizes. When the market crashes, the same economists suddenly become less visible. It happens that one of them, Robert Merton, who shared a Nobel with Myron Scholes for a theory on predicting financial markets, lives in Mandelbrot’s apartment building. “We do not see him very often these days,” Mandelbrot says, tongue in cheek.

When one looks closely at financial-market data, as Mandelbrot has done throughout his life, unexplained accidents appear to be common—even the rule, so to speak. But if prices prove so erratic, there is no way for investors to become rich by incremental investments, Mandelbrot believes. Any portfolio can only follow the market, not beat it.

But some investors do make fortunes, right? “Yes, this is called ‘luck,’ ” answers Mandelbrot. As the financial market is prone to major accidents, one can strike it rich by being positioned luckily on the right side of the road. All major fortunes on the financial market have basically been made in a day, never on an incremental basis, he maintains. Soros comes to mind: in 1992, he earned $2 billion betting against the British pound. He got lucky and never did it again. Since that day, he has managed his fortune, and his faithful clients’ fortunes, by following the ups and downs of market volatility.

Mandelbrot suggests no alternative approach to the theories that pretend to predict volatility. “My role as a scientist,” he says, “is to demonstrate that available theories are plainly wrong. This does not mean that in my own turn I will invent a substitute snake oil that will make you rich.” The financial market is inherently a dangerous place to be, he emphasizes. “By drawing your attention to the dangers, I will not make you rich, but I could help you avoid bankruptcy. I am a doomsday prophet—I promise more blood and tears than windfall profits.”

Both scientists and the public like to believe in what Mandelbrot calls “mild randomness,” in which ordinary laws of probability apply, as is the case with many phenomena in nature. This happens not to be the case with financial markets. History—as well as Mandelbrot’s own empirical research, beginning with a famous 1960s study of the unpredictability of cotton prices—shows that the law of the financial markets is instead “wild randomness,” and that no mathematical model will ever be able to tame it.

Hoover's pro-labor stance helped cause Great Depression, economist saysAugust 28th, 2009 By Meg Sullivan (PhysOrg.com) -- Pro-labor policies pushed by President Herbert Hoover after the stock market crash of 1929 accounted for close to two-thirds of the drop in the nation's gross domestic product over the two years that followed, causing what might otherwise have been a bad recession to slip into the Great Depression, a UCLA economist concludes in a new study. "These findings suggest that the recession was three times worse — at a minimum — than it would otherwise have been, because of Hoover," said Lee E. Ohanian, a UCLA professor of economics. The policies, which included both propping up wages and encouraging job-sharing, also accounted for more than two-thirds of the precipitous decline in hours worked in the manufacturing sector, which was much harder hit initially than the agricultural sector, according to Ohanian. "By keeping industrial wages too high, Hoover sharply depressed employment beyond where it otherwise would have been, and that act drove down the overall gross national product," Ohanian said. "His policy was the single most important event in precipitating the Great Depression." The findings are slated to appear in the December issue of the peer-reviewed Journal of Economic Theory and were posted today on the website of the National Bureau of Economic Reasearch (www.nber.org) as a working paper. Hoover's approach is unlikely to be considered today as a means of responding to economic crisis, but it does illustrate the perils of ill-conceived government policies in times of economic upheaval and confusion, says Ohanian, a macroeconomist who specializes in economic crises. "Hoover's response illustrates the danger of knee-jerk policy reactions in a time of crisis," he said. "Almost always when bad policies are adopted, it's during a period of crisis. The real risk is picking a cure that turns out to be worse than the disease." While economists have long debated the factors that led to the Great Depression, Ohanian's findings are novel because they don't simply pinpoint — they also quantify — the considerable impact of such labor-market distortions. The findings also challenge Hoover's pro-market reputation. "This was a president who had served as secretary of commerce under his predecessor, yet many of the mistakes he made were remarkably similar to those later made by Franklin D. Roosevelt, whose reputation is much less market-based and more pro-labor," Ohanian said. To isolate the culprit of the Depression, Ohanian spent four years sifting through historic wage data from the Conference Board, information from Hoover's own memoirs and press accounts of the Hoover administration. Ohanian also conducted sophisticated economic modeling that allowed him to see how the economy would have progressed had Hoover's policies not been enacted. At the time, Hoover was concerned about two potential crises, Ohanian found. He was afraid the stock market collapse of October 1929 would result in a recession with deflation, leading to dramatic wage cuts, as a period of deflation had done just a decade earlier. And because of a series of recent legislative and court decisions that had expanded the power of organized labor, he also worried about the possibility of crippling strikes if such wage cuts were to come to pass. "Hoover had the idea that if wages were kept high for workers and they shared jobs instead of being laid off, they would be able to buy more goods and services, which would help the economy improve," Ohanian said. After the crash, Hoover met with major leaders of industry and cut a deal with them to either maintain or raise wages and institute job-sharing to keep workers employed, at least to some degree, Ohanian found. In response, General Motors, Ford, U.S. Steel, Dupont, International Harvester and many other large firms fell in line, even publicly underscoring their compliance with Hoover's program. Designed to placate labor and safeguard workers' buying power, the step had an unintended effect: As deflation eventually did set in, the inflation-adjusted value of these wages rose over time, effectively giving workers a raise precisely at the time when companies were least in a position to afford such increases and precisely when productivity was beginning to fall. "The wage freeze effectively raised the cost of labor and, by extension, production," Ohanian said. "If you artificially raise the price of production, your costs go way up and you pass them on to the customers, and they buy that much less." Reluctant to lower wages due to Hoover's entreaties, employers in the manufacturing sector responded by reducing the work week and laying off workers. By September 1931, the manufacturing sector was already hurting: Hours clocked by workers had fallen by 20 percent and employment by 35 percent. Overall, the economy suffered, with the GDP falling by 27 percent. In a situation in which wages would have been expected to fall, they remained at about 92 percent of what they had been two years earlier. When adjusted for deflation, they had actually climbed by 10 percent, Ohanian found. Interestingly, during the dreaded period of deflation a decade earlier, some manufacturing wages fell 30 percent. GDP, meanwhile, only dropped by 4 percent. "The Depression was the first time in the history of the U.S. that wages did not fall during a period of significant deflation," Ohanian said. The paper, "What — or Who — Started the Great Depression" is not Ohanian's first research on the underlying causes of this dark period in American history. Along with former UCLA economics professor Harold L. Cole (now a professor of economics at the University of Pennsylvania), Ohanian published research in 2004 indicating that Roosevelt's response also had an unintentionally deleterious effect. By their calculations, fallout from Roosevelt's National Industrial Recovery Act (NIRA) dragged out the Depression for seven years longer than a more market-based response would have. While several other economists have also implicated Roosevelt in the Great Depression's extensive duration, the UCLA research is unique because it is based on mathematical models that pinpointed the exact extent to which Roosevelt's policies prolonged the Depression, according to the UCLA economists. They calculated that the policies accounted for 60 percent of the Depression's duration. Similarly, Hoover's employment policies have been cited as a precipitating factor in Depression. But the latest UCLA study uses modern economic tools to quantify the impact of the president's wage freeze and job-sharing policies and also provides a theory for why the major industrial businesses followed Hoover's request. By Ohanian's calculation, Hoover's policies accounted for 18 percent of the 27 percent decline in the nation's GDP by the fourth quarter of 1931. Often-cited causes of the Depression include banking failures and large contractions of the money supply. The problem is, Ohanian says, neither of these events occurred significantly until mid-1931 — nearly two years after Hoover's fateful wage policies. Moreover, unemployment did not plague the part of the labor force that was exempt from Hoover's 1929 wage policy. While farm employment would be reduced by Dust Bowl climatic conditions in 1935, at the outset of the Depression it remained surprisingly strong, Ohanian found. In fact, hours clocked in the agricultural sector, which comprised about 30 percent of the workforce at the time, were roughly unchanged through 1931. And unlike in the manufacturing sector, agricultural wages fell dramatically, by 30 percent. "Wages fell substantially, but farm employment rates held steady until the Dust Bowl," Ohanian said. Despite continued calls from industry for wage cuts in 1930 and 1931, Hoover held industry to their original promise, Ohanian found. By late 1931, manufacturers requested that Hoover provide relief in the form of increasing their ability to collude for price-setting purposes. Hoover denied this request. In response, industry signaled they would no longer support the wage freeze. "In late 1931, industry finally did cut wages, but it was too late," Ohanian said. "By this point, the economy was in an unprecedented, full-blown depression." Source: University of California - Los Angeles

Private credit is contracting on both sides of the Atlantic. The M3 money data is flashing early warning signals of a deflation crisis next year in nearly half the world economy. Emergency schemes that have propped up spending are being withdrawn, gently or otherwise.

Unemployment benefits have masked social hardship unto now but these are starting to expire with cliff-edge effects.The jobless army in Spain will be reduced to €100 a week; in Estonia to €15.

Whoever wins today's elections in Germany will face the reckoning so deftly dodged before. Kurzarbeit, that subsidises firms not to fire workers, is running out. The cash-for-clunkers scheme ended this month. It certainly "worked".

Car sales were up 28pc in August, but only by stealing from the future. The Center for Automotive Research says sales will fall by a million next year: "It will be the largest downturn ever suffered by the German car industry."

Fiat's Sergio Marchionne warns of "disaster" for Italy unless Rome renews its car scrappage subsidies. Chrysler too will see some "harsh reality" following the expiry of America's scheme this month. Some expect US car sales to slump 40pc in September.

Weaker US data is starting to trickle in. Shipments of capital goods fell by 1.9pc in August. New house sales are stuck near 430,000 – down 70pc from their peak – despite an $8,000 tax credit for first-time buyers. It expires in November.

We are moving into a phase when most OECD states must retrench to head off debt-compound traps.

If you look at the sheer scale of global stimulus this year, what shocks is how little has been achieved. China's exports were down 23pc in August; Japan's were down 36pc; industrial production has dropped by 23pc in Japan, 18pc in Italy, 17pc in Germany, 13pc in France and Russia and 11pc in the US.

Call this a "V-shaped" recovery if you want. Markets are pricing in economic growth that is not occurring.

The overwhelming fact is that private spending has slumped in the deficit countries of the Anglosphere, Club Med, and East Europe but has not risen enough in the surplus countries (East Asia and Germany) to compensate. Excess capacity remains near post-war highs across the world.

Yet hawks are already stamping feet at key central banks.

Are they about to repeat the errors made in early 2007, and then again in the summer of 2008, when they tightened – or made hawkish noises – even as the underlying credit system fell apart?Fed chairman Ben Bernanke spoke in April 2008 of "a return to growth in the second half of this year", and again in July 2008 that growth would "pick up gradually over the next two years".He could only have thought such a thing if he was ignoring the money data. Key aggregates had been in free-fall for months.

I cited monetarists in July 2008 warning that the lifeblood of the Western credit was "draining away". For whatever reason (the lockhold of New Keynesian ideology?) the Fed missed the signal.So did the European Central Bank when it raised rates weeks before the Lehman collapse, blathering about a "1970s inflation spiral."

Yes, the money entrails can mislead. The gurus squabble like Trotskyists. But you ignore the data at your peril.

Tim Congdon from International Monetary Research says that US bank loans have been falling at an annual pace of almost 14pc since early Summer: "There has been nothing like this in the USA since the 1930s."

M3 money has been falling at a 5pc rate; M2 fell by 12pc in August; the Commercial Paper market has shrunk from $1.6 trillion to $1.2 trillion since late May; the Monetary Multiplier at the St Louis Fed is below zero (0.925). In Europe, M3 money has been contracting at a 1pc rate since April.

Private loans have fallen by €111bn since January. Whether you see a credit crunch in Euroland depends where you sit. It is already garrotting Spain. Germany's Mittelstand says it is "a reality", even if not for big companies that issue bonds. The Economy Ministry is drawing up plans for €250bn in state credit, knowing firms will be unable to roll over debts.

Bundesbank chief Axel Weber sees no crunch now, yet fears a second pulse of the crisis this winter. "We are threatened by stress from our domestic credit industry through the rise in the insolvency of firms and households," he says.

Draw your own conclusion. Western central banks will have to "monetize" deficits on a huge scale to stave off debt deflation. The longer they think otherwise, the worse it will be.

By ROBERT J. BARRO AND CHARLES J. REDLICK The global recession and financial crisis have refocused attention on government stimulus packages. These packages typically emphasize spending, predicated on the view that the expenditure "multipliers" are greater than one—so that gross domestic product expands by more than government spending itself. Stimulus packages typically also feature tax reductions, designed partly to boost consumer demand (by raising disposable income) and partly to stimulate work effort, production and investment (by lowering rates).

World War II defense spending offers a good measure of stimulus effects.

The existing empirical evidence on the response of real gross domestic product to added government spending and tax changes is thin. In ongoing research, we use long-term U.S. macroeconomic data to contribute to the evidence. The results mostly favor tax rate reductions over increases in government spending as a means to increase GDP.

For defense spending, the principal long-run variations reflect the buildups and aftermaths of major wars—World War I, World War II, the Korean War and, to a much lesser extent, the Vietnam War. World War II tends to dominate, with the ratio of added defense spending to GDP reaching 26% in 1942 and 17% in 1943, and then falling to -26% in 1946.

Wartime spending is helpful for estimating spending multipliers for three key reasons. First, the variations in spending are large and include positive and negative values. Second, since the main changes in military spending are independent of economic developments, it is straightforward to isolate the direction of causation between government spending and GDP. Third, unlike many other countries during the world wars, the U.S. suffered only moderate loss of life and did not experience massive destruction of physical capital. In addition, because the unemployment rate in 1940 exceeded 9% but then fell to 1% in 1944, there is some information on how the multiplier depends on the strength of the economy.

For annual data that start in 1939 or earlier (and, thereby, include World War II), the defense-spending multiplier that applies at the average unemployment rate of 5.6% is in a range of 0.6-0.7. A multiplier less than one means that, overall, other components of GDP fell when defense spending rose. Empirically, our research shows that most of the fall was in private investment, with personal consumer expenditure changing little.

Our research also shows that greater weakness in the economy raises the estimated multiplier: It increases by around 0.1 for each two percentage points by which the unemployment rate exceeds its long-run median of 5.6%. Thus the estimated multiplier reaches 1.0 when the unemployment rate gets to about 12%.

To evaluate typical fiscal-stimulus packages, however, nondefense government spending multipliers are more important. Estimating these multipliers convincingly from U.S. time series is problematical, however, because the movements in nondefense government purchases (dominated since the 1960s by state and local outlays) are closely intertwined with the business cycle. Thus the explanation for much of the positive association between nondefense spending and GDP is that government spending increased in response to growing GDP, rather than the reverse.

The effects of tax rates on GDP growth can be analyzed from a time series we've constructed on average marginal income-tax rates from federal and state income taxes and the Social Security payroll tax. Since 1950, the largest declines in the average marginal rate from the federal individual income tax occurred under Ronald Reagan (to 21.8% in 1988 from 25.9% in 1986 and to 25.6% in 1983 from 29.4% in 1981), George W. Bush (to 21.1% in 2003 from 24.7% in 2000), and Kennedy-Johnson (to 21.2% in 1965 from 24.7% in 1963). Tax rates rose particularly during the Korean War, the 1970s and the 1990s. The average marginal tax rate from Social Security (including payments from employees, employers and the self-employed) expanded to 10.8% in 1991 from 2.2% in 1971 and then remained reasonably stable.

For data that start in 1950, we estimate that a one-percentage-point cut in the average marginal tax rate raises the following year's GDP growth rate by around 0.6% per year. However, this effect is harder to pin down over longer periods that include the world wars and the Great Depression.

It would be useful to apply our U.S. analysis to long-term macroeconomic time series for other countries, but many of them experienced massive contractions of real GDP during the world wars, driven by the destruction of capital stocks and institutions and large losses of life. It is also unclear whether other countries have the necessary underlying information to construct measures of average marginal income-tax rates—the key variable for our analysis of tax effects in the U.S. data.

The bottom line is this: The available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. Defense-spending multipliers exceeding one likely apply only at very high unemployment rates, and nondefense multipliers are probably smaller. However, there is empirical support for the proposition that tax rate reductions will increase real GDP.

Mr. Barro is a professor of economics at Harvard. Mr. Redlick is a recent Harvard graduate. This op-ed is based on a working paper issued by the National Bureau of Economic Research in September.

Rumors are flying that secret meetings are taking place between Arab states, China, Russia, Japan and France, to dump the dollar and replace the U.S. currency’s role in the pricing of oil. The dollar fell against the euro, yen and Swiss franc, while gold hit new highs of $1,041 an ounce.

Is there any truth to the rumors that the dollar is being replaced by a basket of foreign currencies, and what will be the impact your investments and the U.S. economy?

The fact is that this rumor has been making the rounds for years. It has been repeatedly denied by officials, but that doesn’t mean foreigners are happy with the falling dollar.

But facts are a stubborn thing: The dollar is still the world’s currency. Oil, gold and other commodities have to be conveniently priced in some currency, and the dollar has traditionally been the currency of choice for a variety of reasons: The United States remains by far the world’s largest economy and trading partner. It remains the only military superpower. And the Federal Reserve is the most powerful central bank.

The Treasury securities market is the world’s largest liquid market. Where else is China going to keep its foreign exchange reserves of $2.1 trillion? As of July 2009, foreigners owned the following amounts in U.S. Treasuries:

In short, the United States is the 800-pound gorilla, and will continue to be the principal investment vehicle for foreign reserves.

Now of course the Chinese and other foreign countries will make every effort to diversify their holdings into euros, yen, Swiss francs, and British pounds, as well as stockholding gold and other commodities.

That’s just prudent diversification.

And that’s what’s happening. Last week, the IMF reported that the dollar's share of total reserves has fallen to its lowest level since 1995.

Despite all the talk of pricing oil in another currency, the dollar reigns supreme. Russia has been talking about doing a oil contract in Rubbles for years, but it hasn’t happened. The Arabs lost out to the New York Mercantile Exchange in the early 1980s in setting the price of crude. Crude oil is the world's most actively traded commodity, and the NYMEX light sweet crude oil futures contract is the world's most liquid form for crude oil trading, as well as the world's largest-volume futures contract trading on a physical commodity, and the pricing is in dollars. So far, changing the pricing to a basket of foreign currencies has proven unworkable.

The biggest risk is a massive crash or run on the dollar, and that’s always conceivable if the Federal Reserve engages in reckless irresponsible monetary policy.

The dollar has fallen sharply this year, losing over 20% against the euro, but so far it’s been an orderly decline.

In order for the dollar to rally, the Fed needs to abandon its “zero” interest rate policy, the Obama administration needs to reign in its deficit spending, and the US economy needs to recover sharply from the Great Recession. So far neither event has happened.

Until these three events occur, it would be wise for investors to keep buying gold and silver, especially silver. Gold has hit new highs, but silver at $17 an ounce is still way below its all time high of $50 an ounce set in 1980.

(I recommend the major chapter on gold in my book, EconoPower: How a New Generation of Economists is Transforming the World (Wiley, 2008).)

Mr. Skousen is a renowned financial economist, author and university professor. He has been the editor of the financial advice newsletter, Forecasts & Strategies, for 28 years. Two of his books highlight Milton Friedman's career: "The Making of Modern Economics" and "Vienna and Chicago, Friends or Foes?." Check out his latest book "The Big Three in Economics: Adam Smith, Karl Marx, And John Maynard Keynes" or "Investing in One Lesson" and "EconoPower: How a New Generation of Economists is Transforming the World." He is the producer of FreedomFest, the world's largest gathering of free minds, in Las Vegas every July (www.freedomfest.com).

PAAS is my investment in silver and it is doing VERY nicely, but I would hesitate to use the high of $50 in any evaluation-- wasn't that number generated by the Hunt brothers trying to corner the silver market?

Is a 20% decline in one year for the world's primary currency truly "orderly"?

Yes interest rate increases can/would dramatically increase the dollar's exchange rate, but with the deficits and debt already in the pipeline and seditious motivations in the White House to devalue our debt, how much do we want to rely upon that?

This post is one in a series entitled Posthumous Refutations. Previously in this series: Cash for Cranks.

Here is a statement release from Christina Roemer, quick to take today's employment report as...

...the most hopeful sign yet that the stabilization of financial markets and the recovery in economic growth may be leading to improvements in the labor market. (...)There are many bumps in the road ahead. The monthly employment and unemployment numbers are volatile and subject to substantial revision. Therefore, it is important not to read too much into any one monthly report, positive or negative. But, it is clear we are moving in the right direction.I've done a lot of driving today, so I've heard a lot of coverage of the employment report on the radio, and the only misgivings about it that I heard was that it might be a "blip". There was nary a whisper that just perhaps the specific jobs created in the specific industries they were created in might be unsustainable. Even some mainstream commentators admit that the easy credit policies of the Fed at least contributed to the bubble in the first place. Yet, with Bernanke having doubled the Fed's balance sheet in order to keep interest rates around 0%, is it such a hard connection to make that an even more extreme easy credit policy just might induce a false-recovery bubble?

In fact, this rebound in employment, following a "jobless recovery" in capital markets (as evidenced in the bull market we've been having) strikes me as perfectly fitting the Austrian Business Cycle Theory's characterization of an economic bubble.

...what happens when the rate of interest falls... from government interference that promotes the expansion of bank credit? In other words, if the rate of interest falls artificially, due to intervention, rather than naturally, as a result of changes in the valuations and preferences of the consuming public?What happens is trouble. For businessmen, seeing the rate of interest fall, react as they always would and must to such a change of market signals: They invest more in capital and producers' goods. Investments, particularly in lengthy and time-consuming projects, which previously looked unprofitable now seem profitable, because of the fall of the interest charge. In short, businessmen react as they would react if savings had genuinely increased: They expand their investment in durable equipment, in capital goods, in industrial raw material, in construction as compared to their direct production of consumer goods...which would explain the recent run-up in the housing market (durable goods) and the stock markets (capital goods). It is only later that

...eventually this money gets paid out in ... higher wages to workers in the capital goods industries....higher wages being, of course, a function of an increased demand for labor: thus today's labor market rebound.

What comes next in the narrative should put quite a damper on Roemer's upbeat view of today's jobs report and the labor market upswing it may represent:

The problem comes as soon as the workers and landlords--largely the former, since most gross business income is paid out in wages--begin to spend the new bank money that they have received in the form of higher wages. For the time-preferences of the public have not really gotten lower; the public doesn't want to save more than it has. So the workers set about to consume most of their new income, in short to reestablish the old consumer/saving proportions. This means that they redirect the spending back to the consumer goods industries, and they don't save and invest enough to buy the newly-produced machines, capital equipment, industrial raw materials, etc. This all reveals itself as a sudden sharp and continuing depression...Now that doesn't sound like a "right direction" to me.

What Christina Roemer does not understand is that, for society as a whole, jobs are not ends in and of themselves. For society, they are only a boon insofar as they produce goods and services without consuming capital. For society, they are liabilities insofar as they are allocated toward unsustainable projects, as they will tend to be under artificial credit expansion. The consequences of Bernanke's mind-boggling credit expansion will eventually catch up to us. Far from being a sign of better days to come, the job report everybody's so excited about today may very well be a harbinger of those consequences.

Ben S. Bernanke doesn't know how lucky he is. Tongue-lashings from Bernie Sanders, the populist senator from Vermont, are one thing. The hangman's noose is another. Section 19 of this country's founding monetary legislation, the Coinage Act of 1792, prescribed the death penalty for any official who fraudulently debased the people's money. Was the massive printing of dollar bills to lift Wall Street (and the rest of us, too) off the rocks last year a kind of fraud? If the U.S. Senate so determines, it may send Mr. Bernanke back home to Princeton. But not even Ron Paul, the Texas Republican sponsor of a bill to subject the Fed to periodic congressional audits, is calling for the Federal Reserve chairman's head.

I wonder, though, just how far we have really come in the past 200-odd years. To give modernity its due, the dollar has cut a swath in the world. There's no greater success story in the long history of money than the common greenback. Of no intrinsic value, collateralized by nothing, it passes from hand to trusting hand the world over. More than half of the $923 billion's worth of currency in circulation is in the possession of foreigners.

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Associated Press

President Richard M. Nixon after his Aug. 15, 1971, speech which established that dollars could not be exchanged for gold..In ancient times, the solidus circulated far and wide. But it was a tangible thing, a gold coin struck by the Byzantine Empire. Between Waterloo and the Great Depression, the pound sterling ruled the roost. But it was convertible into gold—slip your bank notes through a teller's window and the Bank of England would return the appropriate number of gold sovereigns. The dollar is faith-based. There's nothing behind it but Congress.

But now the world is losing faith, as well it might. It's not that the dollar is overvalued—economists at Deutsche Bank estimate it's 20% too cheap against the euro. The problem lies with its management. The greenback is a glorious old brand that's looking more and more like General Motors.

You get the strong impression that Mr. Bernanke fails to appreciate the tenuousness of the situation—fails to understand that the pure paper dollar is a contrivance only 38 years old, brand new, really, and that the experiment may yet come to naught. Indeed, history and mathematics agree that it will certainly come to naught. Paper currencies are wasting assets. In time, they lose all their value. Persistent inflation at even seemingly trifling amounts adds up over the course of half a century. Before you know it, that bill in your wallet won't buy a pack of gum.

For most of this country's history, the dollar was exchangeable into gold or silver. "Sound" money was the kind that rang when you dropped it on a counter. For a long time, the rate of exchange was an ounce of gold for $20.67. Following the Roosevelt devaluation of 1933, the rate of exchange became an ounce of gold for $35. After 1933, only foreign governments and central banks were privileged to swap unwanted paper for gold, and most of these official institutions refrained from asking (after 1946, it seemed inadvisable to antagonize the very superpower that was standing between them and the Soviet Union). By the late 1960s, however, some of these overseas dollar holders, notably France, began to clamor for gold. They were well-advised to do so, dollars being in demonstrable surplus. President Richard Nixon solved that problem in August 1971 by suspending convertibility altogether. From that day to this, in the words of John Exter, Citibanker and monetary critic, a Federal Reserve "note" has been an "IOU nothing."

From the Solidus to the EuroA guide to currencies through the ages.

Solidus

Art Resource, NY

A gold coin introduced around A.D. 310, early in the reign of Emperor Constantine I. In the Byzantine currency system, it was the prime coin against which other coins could be exchanged and was used in international trade and major payrolls. Its use continued into the 11th century, when Constantine IX began debasing it..Pound sterling

Getty Images

The U.K. currency is the oldest currency still in use. Its paper form was introduced when the Bank of England was formed in 1694..Dollar

American Numismatic Society

The Coinage Act of 1792 affirmed the dollar as the U.S. currency unit and specified that each was to equal the value of the Spanish milled dollar and was to contain 371 4/16 grains of pure, or 416 grains of standard, silver..Euro

Deutsche Bundesbank/Getty Images

This common currency for 16 European Union countries launched on Jan. 1, 1999, replacing, among others, Italy's lira, Germany's Deutsche mark and France's franc. The euro erased most of Western Europe's monetary borders...To understand the scrape we are in, it may help, a little, to understand the system we left behind. A proper gold standard was a well-oiled machine. The metal actually moved and, so moving, checked what are politely known today as "imbalances." Say a certain baseball-loving North American country were running a persistent trade deficit. Under the monetary system we don't have and which only a few are yet even talking about instituting, the deficit country would remit to its creditors not pieces of easily duplicable paper but scarce gold bars. Gold was money—is, in fact, still money—and the loss would set in train a series of painful but necessary adjustments in the country that had been watching baseball instead of making things to sell. Interest rates would rise in that deficit country. Its prices would fall, its credit would be curtailed, its exports would increase and its imports decrease. At length, the deficit country would be restored to something like competitive trim. The gold would come sailing back to where it started. As it is today, dollars are piled higher and higher in the vaults of America's Asian creditors. There's no adjustment mechanism, only recriminations and the first suggestion that, from the creditors' point of view, enough is enough.

So in 1971, the last remnants of the gold standard were erased. And a good thing, too, some economists maintain. The high starched collar of a gold standard prolonged the Great Depression, they charge; it would likely have deepened our Great Recession, too. Virtue's the thing for prosperity, they say; in times of trouble, give us the Ben S. Bernanke school of money conjuring. There are many troubles with this notion. For one thing, there is no single gold standard. The version in place in the 1920s, known as the gold-exchange standard, was almost as deeply flawed as the post-1971 paper-dollar system. As for the Great Recession, the Bernanke method itself was a leading cause of our troubles. Constrained by the discipline of a convertible currency, the U.S. would have had to undergo the salutary, unpleasant process described above to cure its trade deficit. But that process of correction would—I am going to speculate—have saved us from the near-death financial experience of 2008. Under a properly functioning gold standard, the U.S. would not have been able to borrow itself to the threshold of the poorhouse.

Anyway, starting in the early 1970s, American monetary policy came to resemble a game of tennis without the net. Relieved of the irksome inhibition of gold convertibility, the Fed could stop worrying about the French. To be sure, it still had Congress to answer to, and the financial markets, as well. But no more could foreigners come calling for the collateral behind the dollar, because there was none. The nets came down on Wall Street, too. As the idea took hold that the Fed could meet any serious crisis by carpeting the nation with dollar bills, bankers and brokers took more risks. New forms of business organization encouraged more borrowing. New inflationary vistas opened.

Not that the architects of the post-1971 game set out to lower the nets. They believed they'd put up new ones. In place of such gold discipline as remained under Bretton Woods—in truth, there wasn't much—markets would be the monetary judges and juries. The late Walter Wriston, onetime chairman of Citicorp, said that the world had traded up. In place of a gold standard, it now had an "information standard." Buyers and sellers of the Treasury's notes and bonds, on the one hand, or of dollars, yen, Deutschemarks, Swiss francs, on the other, would ride herd on the Fed. You'd know when the central bank went too far because bond yields would climb or the dollar exchange rate would fall. Gold would trade like any other commodity, but nobody would pay attention to it.

I check myself a little in arraigning the monetary arrangements that have failed us so miserably these past two years. The lifespan of no monetary system since 1880 has been more than 30 or 40 years, including that of my beloved classical gold standard, which perished in 1914. The pure paper dollar regime has been a long time dying. It was no good portent when the tellers' bars started coming down from neighborhood bank branches. The uncaged teller was a sign that Americans had began to conceive an elevated opinion of the human capacity to manage financial risk. There were other evil omens. In 1970, Wall Street partnerships began to convert to limited liability corporations—Donaldson, Lufkin & Jenrette was the first to make the leap, Goldman Sachs, among the last, in 1999. In a partnership, the owners are on the line for everything they have in case of the firm's bankruptcy. No such sword of Damocles hangs over the top executives of a corporation. The bankers and brokers incorporated because they felt they needed more capital, more scale, more technology—and, of course, more leverage.

In no phase of American monetary history was every banker so courageous and farsighted as Isaias W. Hellman, a progenitor of an institution called Farmers & Merchants Bank and of another called Wells Fargo. Operating in southern California in the late 1880s, Hellman arrived at the conclusion that the Los Angeles real-estate market was a bubble. So deciding—the prices of L.A. business lots had climbed to $5,000 from $500 in one short year—he stopped lending. The bubble burst, and his bank prospered. Safety and soundness was Hellman's motto. He and his depositors risked their money side-by-side. The taxpayers didn't subsidize that transaction, not being a party to it.

In this crisis, of course, with latter-day Hellmans all too scarce in the banking population, the taxpayers have born an unconscionable part of the risk. Wells Fargo itself passed the hat for $25 billion. Hellmans are scarce because the federal government has taken away their franchise. There's no business value in financial safety when the government bails out the unsafe. And by bailing out a scandalously large number of unsafe institutions, the government necessarily puts the dollar at risk. In money, too, the knee bone is connected to the thigh bone. Debased banks mean a debased currency (perhaps causation works in the other direction, too).

Many contended for the hubris prize in the years leading up to the sorrows of 2008, but the Fed beat all comers. Under Mr. Bernanke, as under his predecessor, Alan Greenspan, our central bank preached the doctrine of stability. The Fed would iron out the business cycle, promote full employment, pour oil on the waters of any and every major financial crisis and assure stable prices. In particular, under the intellectual leadership of Mr. Bernanke, the Fed would tolerate no sagging of the price level. It would insist on a decent minimum of inflation. It staked out this position in the face of the economic opening of China and India and the spread of digital technology. To the common-sense observation that these hundreds of millions of willing new hands, and gadgets, might bring down prices at Wal-Mart, the Fed turned a deaf ear. It would save us from "deflation" by generating a sweet taste of inflation (not too much, just enough). And it would perform these feats of macroeconomic management by pushing a single interest rate up or down.

It was implausible enough in the telling and has turned out no better in the doing. Nor is there any mystery why. The Fed's M.O. is price control. It fixes the basic money market interest rate, known as the federal funds rate. To arrive at the proper rate, the monetary mandarins conduct their research, prepare their forecast—and take a wild guess, just like the rest of us. Since December 2008, the Fed has imposed a funds rate of 0% to 0.25%. Since March of 2009, it has bought just over $1 trillion of mortgage-backed securities and $300 billion of Treasurys. It has acquired these assets in the customary central-bank manner, i.e., by conjuring into existence the money to pay for them. Yet—a measure of the nation's lingering problems—the broadly defined money supply isn't growing but dwindling.

The Fed's miniature interest rates find favor with debtors, disfavor with savers (that doughty band). All may agree, however, that the bond market has lost such credibility it once had as a monetary-policy voting machine. Whether or not the Fed is cranking too hard on the dollar printing press is, for professional dealers and investors, a moot point. With the cost of borrowing close to zero, they are happy as clams (that is, they can finance their inventories of Treasurys and mortgage-backed securities at virtually no cost). The U.S. government securities market has been conscripted into the economic-stimulus program.

Neither are the currency markets the founts of objective monetary information they perhaps used to be. The euro trades freely, but the Chinese yuan is under the thumb of the People's Republic. It tells you nothing about the respective monetary policies of the People's Bank and the Fed to observe that it takes 6.831 yuan to make a dollar. It's the exchange rate that Beijing wants.

On the matter of comparative monetary policies, the most expressive market is the one that the Fed isn't overtly manipulating. Though Treasury yields might as well be frozen, the gold price is soaring (it lost altitude on Friday). Why has it taken flight? Not on account of an inflation problem. Gold is appreciating in terms of all paper currencies—or, alternatively, paper currencies are depreciating in terms of gold—because the world is losing faith in the tenets of modern central banking. Correctly, the dollar's vast non-American constituency understands that it counts for nothing in the councils of the Fed and the Treasury. If 0% interest rates suit the U.S. economy, 0% will be the rate imposed. Then, too, gold is hard to find and costly to produce. You can materialize dollars with the tap of a computer key.

Let me interrupt myself to say that I am not now making a bullish investment case for gold (I happen to be bullish, but it's only an opinion). The trouble with 0% interest rates is that they instigate speculation in almost every asset that moves (and when such an immense market as that in Treasury securities isn't allowed to move, the suppressed volatility finds different outlets). By practicing price, or interest-rate, control, the Bank of Bernanke fosters a kind of alternative financial reality. Let the buyer beware—of just about everything.

A proper gold standard promotes balance in the financial and commercial affairs of participating nations. The pure paper system promotes and perpetuates imbalances. Not since 1976 has this country consumed less than it produced (as measured by the international trade balance): a deficit of 32 years and counting. Why has the shortfall persisted for so long? Because the U.S., uniquely, is allowed to pay its bills in the currency that only it may lawfully print. We send it west, to the central banks of our Asian creditors. And they, obligingly, turn right around and invest the dollars in America's own securities. It's as if the money never left home. Stop to ask yourself, American reader: Is any other nation on earth so blessed as we?

There is, however, a rub. The Asian central banks do not acquire their dollars with nothing. Rather, they buy them with the currency that they themselves print. Some of this money they manage to sweep under the rug, or "sterilize," but a good bit of it enters the local payment stream, where it finances today's rowdy Asian bull markets.

A monetary economist from Mars could only scratch his pointy head at our 21st century monetary arrangements. What is a dollar? he might ask. No response. The Martian can't find out because the earthlings don't know. The value of a dollar is undefined. Its relationship to other currencies is similarly contingent. Some exchange rates float, others sink, still others are lashed to the dollar (whatever it is). Discouraged, the visitor zooms home.

Neither would the ghosts of earthly finance know what to make of things if they returned for a briefing from wherever they were spending eternity. Someone would have to tell Alexander Hamilton that his system of coins is defunct, as is, incidentally, the federal sinking fund he devised to retire the public debt (it went out of business in 1960). He might have to hear it more than once to understand, but Congress no longer "coins" money and regulates the value thereof. Rather, it delegates the work to Mr. Bernanke, who, a noted student of the Great Depression, believes that the cure for borrowing too much money is printing more money.

Walter Bagehot, the Victorian English financial journalist, would be in for a jolt, too. It would hardly please him to hear that the Fed had invoked the authority of his name to characterize its helter-skelter interventions of the past year. In a crisis, Bagehot wrote in his 1873 study "Lombard Street," a central bank should lend without stint to solvent institutions at a punitive rate of interest against sound collateral. At least, Bagehot's shade might console itself, the Fed was faithful to the text on one point. It did lend without stint.

If Bagehot's ghost would be chagrined, that of Bagehot's sparring partner, Thomson Hankey, would be exultant. Hankey, a onetime governor of the Bank of England, denounced Bagehot in life. No central bank should stand ready to bail out the imprudent, he maintained. "I cannot conceive of anything more likely to encourage rash and imprudent speculation..., " wrote Hankey in response to Bagehot. "I am no advocate for any legislative enactments to try and make the trading community more prudent."

Hankey believed in the price system. It might pain him to discover that his professional descendants have embraced command and control. "We should have required [banks to hold] more capital, more liquidity," Mr. Bernanke rued in a Senate hearing on Thursday. "We should have required more risk management controls." Roll over, Isaias Hellman.

So our Martian would be mystified and our honored dead distressed. And we, the living? We are none too pleased ourselves. At least, however, being alive, we can begin to set things right. The thing to do, I say, is to restore the nets to the tennis courts of money and finance. Collateralize the dollar—make it exchangeable into something of genuine value. Get the Fed out of the price-fixing business. Replace Ben Bernanke with a latter-day Thomson Hankey. Find—cultivate—battalions of latter-day Hellmans and set them to running free-market banks. There's one more thing: Return to the statute books Section 19 of the 1792 Coinage Act, but substitute life behind bars for the death penalty. It's the 21st century, you know.

James Grant, editor of Grant's Interest Rate Observer, is the author, most recently, of "Mr. Market Miscalculates" (Axios Press).

Planning the Next BubbleNow that the housing bubble has burst, will government create a green-energy bubble?

By Kling & Schulz

This recession was not planned. The recovery will not be planned, either. One of the great conceits of Keynesian economics is that economic performance can be controlled by government technocrats. The reality is rather different.

The housing bubble that finally burst last year was pumped up by at least three forces: new technology, media and industry hype, and, most consequentially, government planning. Without these three there is no way the housing bubble could have grown so large.

When the dot-com bubble burst in 2000, our government geniuses “solved” the problem of the resulting recession by creating a housing bubble. Now that this plan has exploded to disastrous effect, the planners have come up with their next great project — creating a “green” economy.

During the housing boom, the business and political media were filled with fawning profiles of innovative and ambitious lenders, such as New Century Financial and Countrywide, and visionary homebuilders, such as Toll Brothers and KB Home, which were helping redesign the American dream. Barron’s touted Countrywide’s Angelo Mozilo as one of the world’s most admired corporate leaders for three years in a row. New Century was third on the Wall Street Journal’s “Top Guns” list of best-performing companies as recently as 2005.

Today, the pages of the elite media are filled with stories of Silicon Valley’s venture capitalists boldly investing in green tech, GE’s much-lauded efforts to power a green-energy future, and clean-tech automakers such as Fisker that hope to take on the world’s car majors.

During the housing bubble, politicians of both parties cheered every uptick in the rate of home ownership, heedless of the fragile and unsustainable financing methods behind it. Today, government policymakers can’t conceive of any limit to the benefits of switching to green energy. A big part of the Obama administration’s stimulus effort has been geared toward eco-friendly energy technologies. Republican hawks who want to wean the country off Middle Eastern oil also heavily promote renewable and other energy projects. Energy Secretary Steven Chu is picking winners in the green automotive and energy-generation sectors. Using our money as venture capital, he has provided the electric-car maker Fisker with $500 million in loan guarantees. This, even though Fisker already had substantial investments from the venture-capital firm Kleiner Perkins (the firm of which Al Gore is a partner; another partner, John Doerr, is a member of Obama’s Economic Recovery Advisory Board).

Indeed, we might see increased efforts to inflate a green bubble in the coming years as the Obama administration sees renewable energy as a way of driving down the unemployment rate. In a speech last week at the Brookings Institution touting proposals for job creation, President Obama urged Congress to “consider a new program to provide incentives for consumers who retrofit their homes to become more energy efficient, which we know creates jobs, saves money for families, and reduces the pollution that threatens our environment.”

Further, he proposed expanding “select Recovery Act initiatives to promote energy efficiency and clean-energy jobs which have proven particularly popular and effective. . . . With additional resources, in areas like advanced manufacturing of wind turbines and solar panels, for instance, we can help turn good ideas into good private-sector jobs.”

The echoes of the efforts to expand home ownership are eerie. Expanding the housing supply was always justified in part because it, too, could “create jobs.” A little over ten years ago, then-HUD chief Andrew Cuomo testified before Congress that “we must work to do two key things: We must create housing, and we must create jobs.” He then asked Congress for billions of dollars of loan guarantees and millions of dollars of subsidies that would “help create jobs and leverage private investment.” President Bush was similarly enthusiastic about boosting home ownership, no matter the costs. His former economics adviser Larry Lindsey admitted one year ago that “No one wanted to stop that bubble. It would have conflicted with the president’s own policies.”

And we have now seen how those policies, promoted by both political parties, have turned out. Does anyone doubt today that if a green-energy bubble emerges, President Obama’s own advisers will stay silent, as popping such a bubble would conflict with the president’s own policies?

There is no doubt that the boosters of green-energy programs have their hearts in the right place. But then, so did most of those who were pumping up the housing bubble.

If Congress and the president want to push the country in a greener direction, there are easier — and safer — ways of doing it. Put a price, in the form of a tax, on the pollution or emissions you don’t want (such as carbon). And subsidize early-stage, basic research at the university and lab levels.

Beyond that, let the unique power of the market to experiment through trial and error and to sort and filter innovations proceed without meddling. And let entrepreneurs compete vigorously to pump those innovations into the marketplace without government’s attempting to pick winners and losers. Otherwise we are setting the stage for another bubble. It likely won’t be as large as the housing bubble, but it will be costly and wasteful all the same.

— Arnold Kling is a member of the Mercatus Center's Financial Markets Working Group. Nick Schulz is DeWitt Wallace fellow at the American Enterprise Institute and editor of American.com. They are the authors of From Poverty to Prosperity: Intangible Assets, Hidden Liabilities, and the Lasting Triumph over Scarcity (Encounter, New York, 2009)

I am sympathetic to the notion that BO and his running dog progressives are following the Japanese strategy-- so lets take a look at Japan.

The following article from Pravda on the Hudson, has much that is hideous economics, so caveat lector.

==================TOKYO — The broiled meat is tender and the rice is silky-smooth. But as Japan’s economic recovery falters, beef bowls have come to symbolize one of its most pressing woes: deflation.

Shokuan, which has vending machines but no table service, is an inexpensive place to eat.

Japan’s big three beef bowl restaurant chains, the country’s answer to hamburger giants like McDonald’s, are in a price war. It is a sign, many people say, of the dire state of Japan’s economy that even dirt-cheap beef bowl restaurants must slash their already low prices to keep customers.

The battle has also come to epitomize a destructive pattern repeated across Japan’s economy. By cutting prices hastily and aggressively to attract consumers, critics say, restaurants decimate profits, squeeze workers’ pay and drive the weak out of business — a deflationary cycle that threatens the nation’s economy.

“These cutthroat price wars could usher in another recessionary hell,” the influential economist Noriko Hama wrote in a magazine article that has won much attention. “If we all got used to spending just 250 yen for every meal, then meals priced respectably will soon become too expensive,” she said. “When you buy something cheap, you lower the value of your own life.”

Deflation — defined as a decline in the prices of goods and services — is back in Japan as it struggles to shake off the effects of its worst recession since World War II.

While prices have fallen elsewhere during the global economic crisis, deflation has been the most persistent here: consumer prices among industrialized economies rose by a robust 1.3 percent in the year to November, but fell 1.9 percent in Japan.

In the decline, companies that undercut rivals too aggressively are being chastised as reckless at best, or as traitors undermining the country’s recovery at worst. Every markdown of beef bowl prices by the big three restaurants — Sukiya, Yoshinoya and Matsuya — has been promptly broadcast by the national news media here.

Japan has reason to be worried. Deflation hampered Japan from the mid-1990s, after the collapse of its bubble economy, to at least 2005. Households held back spending on big-ticket goods, knowing they would only get cheaper. Companies were unsure of how much to invest. At the time, the three beef bowl chains were in a similar price war.

Still, government officials back then emphasized the supposed benefits of deflation; falling prices were good for households, they said. Others said deflation would help restructure the economy by weeding out weak companies.

But the drawn-out deflationary cycle weighed heavily on Japan’s recovery. Apart from putting a damper on consumption and investment, asset deflation ravaged the country’s banks and shut out new businesses from credit.

Now that deflation is back, Japan is wary. Unemployment remains near record highs, and wages are falling. Mounting public debt is also a problem, causing Standard & Poor’s on Tuesday to cut its outlook for Japan’s sovereign rating for the first time since 2002. Japan must do more to lift its economy out of deflation and bolster long-term growth, S.& P. said.

Moreover, the population is shrinking, making demand inherently weak. Economists say Japan’s economy is saddled with a 35 trillion yen, or $388 billion, “demand gap,” or almost 7 percent of the country’s economic output.

“With supply continuing to exceed demand by a massive margin, deflationary expectations are proving very difficult to shake,” said Ryutaro Kono, an economist at BNP Paribas in Tokyo. “Households have been tightening their purse strings as the income outlook looks increasingly bleak, and we believe firms will continue to respond by lowering prices.”

Matsuya, the smallest of the three chains, set off the price war by cutting the price of its standard beef bowl to 320 yen, or $3.55, from 380 yen in early December. The market leader, Sukiya, followed suit that month, lowering its price to 280 yen, from 330 yen.

This month, the No. 2 beef bowl chain, Yoshinoya, lowered the price of its beef bowl to 300 yen, from 380 yen, though it says the cut is temporary. A smaller chain, Nakau, has also lowered prices.

The restaurant chains insist they have not downsized their portions, and will make up for cheaper prices by raising efficiency.

“We don’t consider this a price cut. We’ve simply set a new price,” said Naoki Fujita at Zensho, which runs the Sukiya chain. “With incomes falling, we needed to figure out what would be a reasonable price,” he said. “We hope customers who came every week will now come twice a week.”

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In a sense, the beef bowl has always been about low prices. Yoshinoya, the beef bowl pioneer with about 1,560 stores in Japan and overseas, helped bring beef to the Japanese working class with its first restaurant in the Nihonbashi district of Tokyo in 1899.

Though beef was a delicacy at the time, Eikichi Matsuda, the Yoshinoya founder, kept prices cheap by buying in bulk, and serving as many customers as possible from his tiny stall. Speed and efficiency reigned, with workers trained to start preparing a bowl even before a customer sat down.The same principles still apply at Yoshinoya. At a branch in central Tokyo, servers rarely take more than a minute to fill an order. The average customer spends just 7.5 minutes on a meal, and a small restaurant can serve more than 3,000 customers a day.

But forced to sell at ever-lower prices — and hurt by lower-priced competitors — making a profit has been increasingly difficult. The company suffered a 2.3 billion yen net loss in the nine months to November, and the next month, before Yoshinoya slashed prices, its sales slumped 22.2 percent. In contrast, sales at Sukiya, which serves up the cheapest beef bowl, surged 15.9 percent that month from the previous year.

Yoshinoya is not considering further price cuts. Squeezing out more savings is “like wringing a dry towel,” said a spokesman, Haruhiko Kizu.

Meanwhile, labor disputes at Sukiya show how falling prices and revenue can quickly hurt workers. A string of former workers have sued the chain over withholding overtime pay. Sukiya denies the accusations.

Other companies have been harshly criticized for slashing prices. Fast Retailing, the company behind the fast-growing Uniqlo brand, has garnered as much disapproval as awe for selling jeans as low as 990 yen. McDonald’s, on the other hand, has won kudos for resisting bargain basement prices by introducing a series of big “American-style” burgers for more than 400 yen, considered expensive in today’s Japan.

“Some Japanese companies are waging such reckless price wars, they’re wringing their own necks,” said Masamitsu Sakurai, who heads the influential business lobby Keizai Doyukai. “Companies need to be more creative. They should come up with products that add value.”

Economists say it is absurd to blame individual companies for Japan’s deflation. “For prices to fall during an economic downturn is natural. That stimulates demand and facilitates an eventual recovery,” said Takuji Aida, chief economist for UBS in Tokyo. “But this mechanism doesn’t work when there is such a big demand shortfall.”

“When prices fall because of an increase in productivity at a company, it’s good for the economy,” said Sean Yokota, an economist for UBS based in Tokyo. “It’s the demand gap that’s damaging.”

The government has vowed to lift household incomes through a series of subsidies, including new cash payments to families with small children. But the scale of government payments — 2.3 trillion yen in the case of the child subsidies — is hardly enough to fill the nation’s huge demand shortfall. With interest rates close to zero, Japan also has few options left in monetary policy.

In the meantime, cutthroat price battles are already driving laggards out of business. Wendy’s, the American burger chain, left Japan on Dec. 31.

It is not surprising, considering the competition. A mere stone’s throw from Tokyo’s celebrated Ginza district is Shokuan, the kind of restaurant that is undercutting everyone.

Shokuan, which has no chairs nor table service, is a cluster of beer vending machines huddled under the train tracks. A man behind a tiny counter sells dirt-cheap morsels: fish sausages for 50 yen, prawn crackers for 60 yen, canned yakitori for 160 yen. Many days of the week, Shokuan is spilling over with customers.

“I don’t think there’s anything around here cheaper than this. That’s why I started to come,” said Yasunori Miura, a manufacturing company employee and a recent regular. “This here,” he said, pointing to his fish sausage, “is deflation.”

With regards to its interest-rate policy, the Federal Reserve has followed the advice from theory by committing to deflation and to keep interest rates at zero for the foreseeable future. It has deviated from the theoretical recommendations by not making a clear commitment to have higher-than-average inflation in the future, and especially by not providing a clear signal that it will keep nominal interest rates low for some time even after the crisis is over.

Scott Sumner might feel a bit less lonely reading this. Thanks to Mark Thoma for the pointer. Reis also tries to explain the Fed's non-standard balance sheet moves.Rather than try to come up with an economic theory to explain Fed policy, I would suggest a more cynical approach. The goal has been to transfer wealth to banks and to the holders of mortgage securities. The thinking is that those constituents are more important to the economy than taxpayers.

Suppose that in 2013 President Palin meets with Ben Bernanke and says, "I want you to sell your entire portfolio of mortgage securities, by close of business today." I don't think that Bernanke could argue that she was interfering with the conduct of monetary policy.

The Fed has changed from a central bank to a piggy bank. Any economist who tries to interpret Fed policy from the standpoint of economic theory is playing a fool's game.

Priceless is worthless: in health care, education, or bonds, the price is (metaphysically) right.

Link to this pageMASTERCARD is right: Some things in life are priceless. Those are the things that don't work. If you care about something--health care, education, a clean environment--put a price on it.

Prices are, or should be, objects of awe and wonder, a mystery to be meditated upon. They are not mere intersections of supply and demand curves, the predictable $19.99 of late-night infomercials: Prices are the Paraclete of the market economy, the mystical intercessor between producers and consumers, making possible miracles of information management and economic coordination that could not otherwise be accomplished. Prices are the epistemological movers and shakers of community life, transporting knowledge instantly and frictionlessly, coordinating the actions of a shipyard in Virginia with those of a steel mill in China, directing global flows of capital, letting clueless executives in Atlanta know that New Coke is a fiasco.

That last bit of Cold War history is worth thinking about: When it hit the market in 1985, New Coke was the most highly engineered, polished, researched, lovingly refined, focus-grouped, test-marketed product of its time. (Socialist governments aren't the only organizations that find their central-planning efforts nullified by the market, which is to say, by reality.) The Coca-Cola Company had everybody from food scientists to psychiatrists working on what they codenamed, in the military-industrial style, Project Kansas. All the best minds told them New Coke was going to be a smashing success, but prices said otherwise: They found that they could not give New Coke away. The price of Old Coke, if you could find it, skyrocketed. Consumers began to spend extraordinary sums of money--to pay very high prices--to import "The Real Thing" from overseas, and an organization calling itself "Old Cola Drinkers of America" was able to raise $120,000 to lobby Coca-Cola for a return to the original formula. Price spoke loud and clear. So poorly regarded was the new product that, in some cities in the South, where Coke is considered an item of particular cultural importance, revanchist cola conservatives paid full price for bottles of New Coke for the sole purpose of emptying them out in the streets as an act of protest. Sales tanked, orders nose-dived, regional bottlers revolted. Coke's brain trust said "X," but prices said "Not X." The price was right.

It took a little trauma to get there, but consumers prevailed, and New Coke followed Communism into the dustbin of history--for similar reasons, but with a lot less bloodshed. The Coca-Cola Company had to bend to reality more quickly than the Marxist-Leninists did. Prices are, among other things, a snapshot of the relationship between what producers are selling and what consumers want. That relationship, though intangible, is a reality, as real as gravity or a skyscraper or a case of pancreatic cancer.

TO compare the contemporaneous declines of New Coke and Soviet Communism from 1985 to 1991 is not to engage in frivolity. As F. A. Hayek noted, the great problem facing central-planning regimes like that of the Soviet Union is that there are no prices to facilitate communication between producers and consumers. The tales of Communist-era production misalignments would be comical if they had not exacted such a high price in human suffering: There would be huge surpluses of, say, pesticides (not to mention tanks and rockets and ideology) but acute shortages of sugar, flour, shoes, and other common items. Toilet paper was used as filler in sausages until that homely commodity itself went into short supply. Burglars would break into houses and steal everything but the money--there was no point in taking it, as there was little or nothing to buy. (That might have changed during the toilet-paper shortage.) For the Soviets, there were no real prices, so there was no feedback loop between producers and consumers: If we'd had that model for soft drinks, we'd still be drinking New Coke, and the cola executives in Atlanta would be strutting around in their nifty military uniforms, with epaulets and braid, telling us to drink our New Coke and like it, because they had determined, RATIONALLY, that this is what we want. A good rule of thumb: Fear the man who says he will make things rational by ignoring reality--and ignoring prices is ignoring reality.

Unhappily, there are sectors of the American economy that are almost as lacking in meaningful prices as those old Soviet shops were. And where the epistemological labor performed by prices goes undone, you may be sure that dysfunction and unhappiness will follow. Most of the occasions that find us lacking good prices are the result of political manipulation of the economy--the allegedly rational government planner overruling prices--but not all of them are. Up until about a decade ago, for example, NASDAQ traders indulged a curious habit of quoting stock prices only in quarter-dollar amounts even though they were actually calculated in amounts of one-eighth of a dollar. (This was back in the pre-decimal Dark Ages of the 1990s.) So a stock that might be offered at one and one-eighth dollars ($1.125) would end up being quoted on the market at one and a quarter ($1.25), increasing the traders' profits. It was a terrible system for everybody but the top dealers and, when the practice was exposed and discontinued, spreads on some high-volume stocks, like Microsoft, dropped by half.

But you don't have to go to Wall Street to find prices being hidden and distorted, with ugly consequences for consumers. One of the most bothersome examples is the lack of price transparency in medical procedures.

A few years ago, needing a medical procedure, I conducted an experiment, partly out of curiosity and partly out of dread of dealing with the insurance bureaucrats who are theoretically paid, by me, to provide me with an agreed-upon service, but who in fact earn their pay in no small part by scheming to renege upon and undermine that agreement in various sneaky ways. I asked my doctor: "If my insurance will not pay for Procedure X, how much would it cost me to pay for it out of pocket?" Doc X looked at me skeptically, as though I had asked to borrow one of his many Ferraris. "Just talk to Alice in our insurance office, and she'll sort out the insurance for you. You may have to jump through some hoops, but they'll cover it." Undeterred (actually, a bit deterred by the many photographs of Ferraris on his office wall), I pressed on: "But, say I didn't have insurance. What would it cost me?" Doc X: "You have insurance." Me: "Yes, but if I want to pay for it myself, how much?" And so on. He had to consult with his business manager. "We bill the insurance companies $25,000 for Procedure X. If you pay for it out of pocket, we charge $18,000." That different parties are charged wildly different prices is one sign of a defective market. Me: "So, is that $18,000 flat? Is there sales tax, or anything else?" Doc X: "The $18,000 is my fee. There's the anesthesiologist, too, and the nurse, and the hospital will have charges, too. And ..." And, as it turns out, there was a whole battery of tests, screenings, pre-procedure procedures, etc., necessary before Procedure X. "So, totaled up, the final bill looks like what?" Doc X is one of the leading practitioners in his field, a man of great learning, and wit, and rarefied taste in fine automobiles. "I have no freaking idea," he said. "You should talk to Alice in insurance." I spent a few days making phone calls, talking to perplexed and befuddled healthcare providers who were absolutely nonplussed by the fact that I wanted to pay them to provide me with health care. The best I could figure was somewhere between $25,000 and $250,000--which is to say, somewhere between a Honda Accord and a Ferrari F430. I talked to Alice in insurance.

OTHERS have reported similar experiences. And even with insurance, it is well nigh impossible to find out in advance how much you will be charged for a particular procedure. Going into a doctor's office for some common blood work, which was covered by my insurance, I tried, very diligently, to discover what I would be charged. "It depends," the receptionist told me. I had the numbers in front of me: My deductible was X, my co-pay was Y, etc. So, "What's the damage?" She: "I don't know." I called Alice in insurance. She didn't know.

Health-care prices are a mishmash for lots of reasons, but one of the main ones is the way we pay for health care--you don't pay the doctor, your insurance company does, an arrangement that gives at least two of the three parties involved a good incentive to obscure prices, so that the consumer has no idea how good or how rotten a deal he is getting while the insurers and hospitals attempt to game and swindle each other. Given the shocking and terrifying size of serious medical bills--my mother's last stay in the hospital billed out at $360,000 (that's a Ferrari 612 Scaglietti for Doc X plus a BMW 5-Series for one of his brats)--the American health-care consumer, quaking in his paper hospital slippers, no longer even asks: "What does this procedure cost?" He only asks: "Does my insurance cover it?" No prices, no negotiation, no mystical coordination between producer and consumer--instead, maddening and expensive and often underhanded mediation by the insurer.

Medicine is complicated; computers are complicated, too, but you can call Dell or Apple or Best Buy or whomever and ask: "What does this sort of computer cost?" and you will receive an answer. And then, when you get to the store--miracle of miracles!--that will be the price. Computers are damned complicated to make, with programmers in the United States and India collaborating with Taiwanese microchip fabricators, Dutch LED manufacturers, Irish customer-support agents, etc. You can get a price on an iMac, but you can't get a price quote on an ingrown toenail.

If I may make a populist-credibility-destroying admission, I live in New York City and I take yoga classes. Yoga is a super-competitive business in New York--there's big money in sweaty enlightenment. Signing up for a series of classes, I was surprised at the specificity of the prices and the number of options available: There's one rate for a one-off class, a discount for buying ten classes at once, another for a month's or a year's worth of classes. You can elect to bring your own yoga mat or to rent one, or to buy your own but have the studio store and clean it for you for a fee. There is a menu of options for towels, lockers, etc. I counted nine major variables that could be combined in various iterations to determine the final cost of a yoga class, with about 2,000 different possible combinations of those options. The yoga jock working the front desk at my studio does not, I would guess, enjoy quite as generous a neurological endowment as Doc X but, unlike Doc X, he could tell me what things would cost. He had the prices right there in front of him: Magic! I suspect that health care would cost less, and that Americans would be much less anxious about it, if rotator-cuff surgeries were priced as transparently as yoga classes or computers or Oreo cookies.

But rather than bring price transparency to health care, we're going full-tilt boogie in the opposite direction, specifically by insisting that insurance companies be barred from putting real prices on preexisting conditions. Set aside, if you can, all those images of poor little children with terrible diseases being chucked out into the Dickensian streets by mean old insurance executives in top hats and monocles, and think, for a second, about what insurance means, and what a preexisting condition is. Insurance is, basically, a bet: The insurer calculates the probability that a certain unhappy condition will befall a consumer. Actuarially speaking, the number of people who will suffer heart disease or car accidents is fairly predictable within a very large pool, so the insurer can figure out roughly what it will have to pay out in a typical year for every 100,000 policies, and the premium will incorporate that number. But predictable applies to things that happen in the future. Maybe 3 percent of those 100,000 people will need to see a cardiologist in a given year, but 100 percent of the people with diabetes will suffer from diabetes. That's a fact: It's what preexisting means.

Unless Governor Schwarzenegger manages to invent Terminator insurance, whereby Allstate agents travel back in time to insure you against problems you haven't developed yet, you cannot insure against something that already has happened, and to pretend otherwise dumps a whole metaphysical can of worms all over the insurance space--time continuum, landing us in an alternative universe where Insurance = Not Insurance. You'd never take a bet that you knew you were going to lose, right? Insurance companies won't do that, either, unless they get paid to do so--specifically, unless they are allowed to charge at least as much for covering Preexisting Condition X as it's going to cost them to treat Preexisting Condition X. Ignoring the reality of prices--waving the magic wand and saying: "There shall be no price put on preexisting conditions"--does not solve the problem. Health care costs money. The price is right, and you cannot politically engineer your way out of that reality, no matter how many sickly toddlers you parade around on CNN.

HEALTH CARE consumes 17 percent of GDP and the cost is growing at 10 percent a year; we spend about $7,000 per capita on it. Is there anything else you're spending seven grand a year on but can't get a price for? Yes, there is, now that you're heavily invested, through your government, in the financial-services industry, with a diverse portfolio of craptastic positions in mortgage-backed securities, wobbly insurance companies, zombie banks, etc. You'd think that Wall Street suits, of all people, would have been paying attention to prices. But they weren't. There were all sorts of pricing problems leading up to the financial crisis, the fundamental one being that the government wanted housing prices to keep going up but also wanted more and more people to buy houses, i.e. they wanted demand to rise with rising prices rather than to fall as prices went higher--which is to say, they wanted magical pixies to plant unicorn trees and fertilize them with faerie dust. We could cloak the effects of rising house prices for a long time--about 60 years, as it turned out--through all sorts of schemes, including the mortgage-interest tax deduction, artificially low mortgage-interest rates, and Fannie Mae and Freddie Mac shenanigans.

Mortgages, like all loans, entail risk, and risk has a price, too, but we managed to find a way around that, creating a federally chartered cartel of credit-rating agencies--Moody's, Standard & Poor's, Fitch--that mindlessly applied the same formula over and over, slapping Triple-Aratings on securities. And it was the Triple-A rating, not the underlying security, that determined the price banks and other investors put on that risk. We inflated the price of houses, depressed the price of mortgages, and cloaked the price of the risks attached to doing so. But as even the Soviets found out, prices are not to be denied forever: The price of housing turned around, back down toward its normal, non--politically adjusted level, taking the price of mortgage-backed securities with it and sending the cost of borrowing, conversely, through the roof. Boom: financial meltdown. Turned out there was a lot of Triple-A toilet paper in our sausage. The lesson: Don't mess with prices!

So we messed with prices some more. Mark-to-market accounting, the rule that says that banks and other financial institutions must value all the assets on their books at the most recent market price, decimated (and then some) the capital of our banks. Interesting thing about mark-to-market: It creates imaginary prices. If Security A sells at Price X, everybody who owns Security A has to write it down on his books to Price X--even if there is no way in tarnation he'd actually sell it at that price. Think of it this way: For almost any asset, there will be times when distressed parties sell at a fire-sale price. A degenerate gambler may hock his wife's diamonds during a bad run in Vegas, but that does not mean that the folks at Tiffany's will start selling the same jewelry at the price the pawnbroker paid. Mark-to-market essentially turned the structured-finance markets into a Quentin Tarantino Mexican standoff, with every bank holding a gun to every other bank's head: In that situation, there were no real market prices for lots of those mortgage-backed securities, because everybody was too terrified to buy or sell and establish a theoretical price that, because of accounting rules that do not reflect economic reality, would require them to rebalance their books, to catastrophic results.

Prices do their thing because of the nature of economic information. Information basically comes in two flavors: You've got your for-the-ages, centralized, Library of Alexandria--type information, your Big Truths that are relevant at all times for all men. These are things like scientific knowledge and works of history, scholarship, philosophy, the grammars and lexicons of ancient languages--you know: stuff practically nobody ever uses. On the other hand, you have contingent, contextual information of the "Got milk?" variety. "Do I need to buy milk, and, if so, how much and what kind?" is an interesting question, because the answer is likely to be different every time you ask. How much milk you and your family need on any given day is likely to vary wildly: If you're whipping up some homemade ice cream for a summertime party, you will probably buy more milk than you usually do. If your fruity daughter goes vegan, you're buying less. Milk is complicated: Survey the magnificence of the dairy aisle! You have choices that are almost incalculable: 0.5 percent, 1 percent, 1.5 percent, 2 percent, skim, whole, organic, grass-fed, chocolate, strawberry, soy, lactose-free, half-pints and pints and gallons. Apply the whole range of choices to hundreds of millions of consumers making hundreds of purchases apiece over the course of a year and you have an information-management problem of a very hairy kind. No central planner, no matter how powerful or gifted, could predict Americans' milk needs in advance or coordinate them with producers. Prices do that.

But milk prices in the United States are not set by the market--they are set by milk-pricing bureaucrats, partly in the employ of the U.S. government and partly in the employ of Big Bessy. Now, we know for a fact that, given the billions of possible distributions in the dairy market, the allegedly rational planners who set milk prices are not evaluating American milk consumption and production in their full glorious complexity. So, how are they making their decisions? Nobody really knows, but the Organization for Economic Cooperation and Development estimates that American families pay 26 percent more for milk than they would pay if they paid real prices, i.e. the prices set by a free market. Whoever's interest is being looked after, it isn't the interest of the guy on a tight budget staring down a dry bowl of Count Chocula. And as we continue to pretend that there is another unseen economic reality beyond market prices when it comes to health care, banking, housing, labor, cotton, sugar, fuel-efficient Japanese automobiles, solar panels, and every other product with prices distorted by politics--whose interests do you imagine are being served? Yours, chump?

In health care, banking, education, and other critical areas, Uncle Sam is putting his big ugly federal boot squarely on the neck of prices, choking off the lifeblood that allows economies to work efficiently and rationally: not perfectly efficiently, not perfectly rationally--that's the stuff of theoretical models and utopian visions--but making the best use of the best information we have. Lowering health-care costs will require consumers to comparison-shop between providers (insurers, doctors, hospitals, specialists) just as reforming Wall Street will require giving investors real prices for the risks they are bearing--and charging "too big to fail" institutions a real price for the subsidy they now collect from taxpayers. We cannot make intelligent reforms without real prices, because we are blind without them. But given that Washington has been setting the price of milk since the 1930s and shows no sign of giving it up, the chances of their taking up the Gospel of Price are slim. Let him with ears, hear.

By David WarrenA spectre is haunting Europe, and America -- the spectre of Keynesianism finally gone nuts.

What began, not very innocently, as a suggestion that governments should run deficits in bad times, and surpluses in good times, gradually "evolved." In the next phase, governments tried to balance at least the operating account during the best of times. In phase three, governments ran deficits by habit during the good times, but much bigger "stimulus" deficits during the bad times. We are now entering phase four.

Canadians tend to feel smug about this, for we look south at a fiscal catastrophe that had nothing to do with us. For the last generation, we have been trying to claw our way back to budgetary conditions before Pierre Trudeau broke the bank. This had once seemed a small price to pay for his "just society" (or "just watch me"). Surely it was worth mortgaging our children's future, and that of their children, and children's children, for the transient privilege of being governed by such a man. (I can still hear the erotic screams of the women, from the 1968 general election, as Trudeau passed by.)

By about 1984, we had had enough. Michael Wilson balanced the operating account, then Paul Martin balanced the overall budget, and today Jim Flaherty tries to keep the federal debt "shrinking" in proportion to national income. (Of course, the debt itself grows and grows.)

We feel smug because we are watching President Barack Obama do for the United States what Prime Minister Trudeau did for us -- although in their case, on top of what Obama's predecessors did. The U.S. national debt now exceeds $12.3 trillion in a $14.2 trillion economy, and the U.S. government is now piling it on with unprecedented new deficits. The U.S. Treasury's borrowing requirement is, as it were, coming up against the Great Wall of China.

Little things, such as the heart of the U.S. space program, are being gutted to make way for metastasizing social security entitlements and debt service payments that will soon swamp the entire federal budget -- thus requiring the elimination of more little things such as the army, navy and air force. At some point the entitlements simply can't be paid, without hyperinflation.

I am not exaggerating. The American debt is now at levels that ring bells at the International Monetary Fund. And as the world's biggest debtor rapidly accelerates its borrowing, the fiscal carrying capacity of the rest of the planet comes into question.

There are two large reasons why we cannot afford to be smug, up here. The first is that after adding the "entitlement" heritage of our provincial governments to the federal debt load, our position is not much better. The second is that even if it were much better, the tsunami coming from south of the border will anyway sweep all our dikes away.

The Obama administration's financial projections are extremely optimistic, yet even if they all come true, the U.S. debt will continue to grow unsustainably. The kind of alarm falsely placed in "global warming" would more usefully be directed towards the remarkable cooling effect this will have, as all our fiscal and demographic trends converge. For this is a predictable future; an issue where the numbers correspond to real things, not to mere speculation.

We can already see where the U.S. is headed, because Iceland and Greece are showing the way. Both have now passed a point of no return, and both are being followed down that plughole by Britain and several other European countries that will probably precede the U.S. into outright bankruptcy. The State of California also gives some clues.

While an optimist would say that we are witnessing the final demise of the welfare state, and good riddance, a pessimist would observe that everything must go down with it. Moreover, as we have seen from the history of Germany and other countries, fiscal catastrophe accentuates every latent threat to public order.

For our governments have created vast bureaucracies, employing immense numbers whose livelihoods depend entirely (whether they realize it or not) upon the capacity of profit-earning people to pay constantly increasing taxes.

It should have been grasped, decades ago, that the constant transfer of resources from the productive to the unproductive must eventually tip the ship. And when it does, real people go over the side, who get angry when they are thrown in the water. There are consequences to that anger.

The idea that we can spend our way out of a debt crisis -- or what I called above, "Keynesianism gone nuts" -- has already been rejected by the Tea Party movement in the U.S., and has always been rejected by voters of conservative tendency. They know what's wrong with the present order, and have an important teaching function to the rest of the electorate, which doesn't get it yet.

But more urgently, we are in need of a positive conception of how to rebuild economy and society, when Nanny State collapses under her own weight. For yelling "run!" is only a short-term solution.

Cash in the clouds—neither paper nor plastic.Illustration: Aegir Hallmundur; Benjamin Franklin: CorbisTHE FUTURE OF MONEYFrom Credit Card to PayPal: 3 Ways to Move MoneyA simple typo gave Michael Ivey the idea for his company. One day in the fall of 2008, Ivey’s wife, using her pink RAZR phone, sent him a note via Twitter. But instead of typing the letter d at the beginning of the tweet — which would have sent the note as a direct message, a private note just for Ivey — she hit p. It could have been an embarrassing snafu, but instead it sparked a brainstorm. That’s how you should pay people, Ivey publicly replied. Ivey’s friends quickly jumped into the conversation, enthusiastically endorsing the idea. Ivey, a computer programmer based in Alabama, began wondering if he and his wife hadn’t hit on something: What if people could transfer money over Twitter for next to nothing, simply by typing a username and a dollar amount?

Money Over TimeA brief history of currency technology. —Bryan Gardiner9000 BC: Cows The rise of agriculture made commodities like cattle and grain ideal proto-currencies: Since everyone knew what a heifer or a bushel was worth, the system was more efficient than barter.Just a decade ago, the idea of moving money that quickly and cheaply would have been ridiculous. Checks took ages to clear. Transferring money from one bank account to another could take days, as banks leisurely handed off funds, levying fees nearly every step of the way. Credit cards made it a little easier to pass money to a friend — provided that friend owned a credit card reader and didn’t mind paying a few percentage points in fees or waiting a couple of days for the payment to process.

Ivey got around that problem by using PayPal. Since 1998, PayPal had enabled people to transfer money to each other instantly. For the most part, its powers were confined to eBay, the online auction company that purchased PayPal in 2002. But last summer, PayPal began giving a small group of developers access to its code, allowing them to work with its super-sophisticated transaction framework. Ivey immediately used it to link users’ Twitter accounts to their PayPal accounts, and his new company, Twitpay, took off. Today, the service has almost 15,000 users.

That may not sound like much, but it sends a message: Moving money, once a function managed only by the biggest companies in the world, is now a feature available to any code jockey. Ivey is just one of hundreds of engineers and entrepreneurs who are attacking the payment ecosystem, seeking out ways small and large to tear down the stronghold the banks and credit card companies have built. Square, a new company founded by Twitter cocreator Jack Dorsey, lets anyone accept physical credit card payments through a smartphone or computer by plugging in a free sugar-cube-sized device — no expensive card reader required. A startup called Obopay, which has received funding from Nokia, allows phone owners to transfer money to one another with nothing more than a PIN. Amazon.com and Google are both distributing their shopping cart technologies across the Internet, letting even the lowliest etailers process credit cards for less than the old price, cutting out middlemen, and figuring out ways to bundle payments to sidestep the credit card companies’ constant nickel-and-diming. Facebook appears to be building its own payment system for virtual goods purchased on its social network and on external sites. And last March, Apple gave iTunes developers the ability to charge subscription fees through their applications, making iTunes the gateway for an entirely new breed of transaction. When Research in Motion announced a similar initiative last fall at a session of the BlackBerry Developer Conference in San Francisco, programmers crowded the room, spilling out into the hallway. About 20 percent of all online transactions now take place over so-called alternative payment systems, according to consulting firm Javelin Strategy and Research. It expects that number to grow to nearly 30 percent in just three years.

But perhaps nobody is as ambitious as PayPal. In November, it further opened up its code, giving anyone with rudimentary programming skills access to the kind of technology and payment-industry experience that Ivey used to build Twitpay. The move could unleash a wave of innovation unlike any we’ve seen since self-publishing came to the Web. Two months after PayPal opened its platform, 15,000 developers had used it to create new payment services, sending $15 million through the company’s pipes. Software developer Big in Japan, whose ShopSavvy program lets people find an item’s cheapest price by scanning its barcode, used PayPal to add a “quick pay” button to its app. LiveOps, a call-center outsourcing firm, built a tool that streamlined payments to its operators, turning what had been a nightmare of invoicing and time-tracking into an automated process. Previously, anybody who wanted to create a service like this would have had to navigate a morass of state and federal regulations and licensing bodies. But now engineers can focus on building applications, while leaving the regulatory and risk-management issues to PayPal. “I can focus on the social side of the business and not on touching money,” as Ivey puts it.

PayPal is just the latest company to try to harness the creative powers of the open Internet. Google created a platform that lets anyone buy or display online advertisements. Facebook allows any developer to write applications for its social network, and Apple does the same with its iTunes App Store. Amazon’s Web Services provides developers the cloud-based processing power and storage space they need to build applications and services. Now PayPal has brought this same spirit of innovation and experimentation to the world of payments. Your wallet may never be the same.

Two months after PayPal opened its platform, 15,000 developers had used it to create new payment services.Illustration: Heads of StateThe banks and credit card companies have spent 50 years building a proprietary, locked-down system that handles roughly $2 trillion in credit card transactions and another $1.3 trillion in debit card transactions every year. Until recently, vendors had little choice but to participate in this system, even though — like a medieval toll road — it is long and bumpy and full of intermediaries eager to take their cut. Take the common swipe. When a retailer initiates a transaction, the store’s point-of-sale system provider — the company that leases out the industrial-gray card reader to the merchant for a monthly fee — registers the sale price and passes the information on to the store’s bank. The bank records its fee and passes on the purchase information to the credit card company. The credit card company then takes its share, authorizes all the previous fees, and sends the information to the buyer’s bank, which routes the remaining balance back to the store. All in all, it takes between 24 and 72 hours for the vendor to get any money, and along the way up to 3.5 percent of the sale has been siphoned away.

In the earliest days of credit cards, those fees paid for an important service. Until the late 1950s, each card was usually tied to a single bank or merchant, limiting its usefulness and resulting in a walletload of unique cards. But when BankAmericard — later renamed Visa — offered to split its fees with other banks, those banks began to offer Visa cards to their customers, and merchants began accepting Visa as a way to drive sales. Meanwhile, Visa and rival MasterCard — as well as distant competitors American Express and Discover — used their share of the fees to build their own global technological infrastructures, pipes that connected all the various banks and businesses to ensure speedy data transmission. For its time, it was a technologically impressive system that, for a price, brought ease and convenience to millions of buyers and sellers.

Money Over TimeA brief history of currency technology. —Bryan Gardiner1200 BC: Shells Rare or exotic items like shells, whale teeth, and metals were used for trade by cultures around the world because their scarcity and beauty lent them great symbolic value. (The earliest Chinese character for money was even a cowry shell.)But today, vendors are seeing fewer benefits from paying those fees, even as credit card companies have jacked them up over the years. Credit cards were once a way for a business to differentiate itself from competitors, but now that they’ve grown ubiquitous, nearly all vendors must accept them or risk losing a huge swath of customers. According to a 2003 study in the Review of Network Economics, every sale by credit card costs a merchant six times what the same sale with cash would run. (Cash comes with its own costs, such as requiring more oversight of cashiers, upkeep of vaults, and a bank’s services to process it.)

Not that the store owner is ever quite sure how much a credit card transaction will cost. MasterCard and Visa charge hundreds of different rates — called interchange fees — for every type of card that runs through their networks; mileage cards tend to charge higher fees, for example. And if a retailer accepts one flavor of Visa, say, it has to accept them all, no matter the fee. In 1991, MasterCard had four fees, the highest of which had an interchange rate of 2.08 percent. Today it has 243 fees, and the heftiest one tops out at over 3 percent — more than a 50 percent jump. And yet the service provided has hardly grown any better, faster, or easier to access. “It seems really odd that credit card companies can continue to charge a tax on the economy,” says Aaron Patzer, founder of the financial management service Mint.com, which is now owned by Intuit. “Outside the US government, they are the only entity that has the power to levy a fee across virtually every transaction. Maybe that made sense in the early 1960s, when computer infrastructure was expensive and proprietary. But now, with cheap bits everywhere, the actual cost to do a transaction is pennies.”

There is, in other words, a massive inefficiency to be exploited. And so, an army of engineers and entrepreneurs is rushing in, hoping to do to the payment world what has already been done to the music, movie, and publishing businesses — unseat a legacy industry built on access and distribution, drive the costs to zero, undercut the traditional middlemen, and unleash a wave of innovation. Square’s Dorsey sees his company as creating a new, open system that allows users to swap funds instantly, without a series of interlopers grabbing their share. “We bring an engineering discipline to this problem,” he says. “What we want to know is, how can we get right to the source?”

For businesses that depend on moving money, the distributed, lower-cost, easier-to-access future can’t come soon enough. Mitchell Wolfe, an ecommerce veteran who ran Compaq’s Canadian Internet sales team before moving on to a series of startups, has been wrestling with the payment industry for 15 years. “There’s friction all over the place,” he says. He once helped build an ecommerce system for a Persian rug vendor and was stunned to find that the rug dealer’s bank required it to keep $250,000 in its account in case a charge was disputed. The lesson stuck. When he started bTrendie, a members-only site that sells clothes and gear for pregnant women and new mothers, he decided to do as much as possible through PayPal. Now he accepts payments from customers into the same PayPal account he uses to pay his vendors. The money flows instantly, bypassing direct contact with banks or credit cards. That means no charges for moving money internationally, no extra staffers, no long delays while he waits for transactions to process, and he can keep better track of his cash and data. For Wolfe, the old payment world is a vestigial appendage. “The less you have to deal directly with the banks and credit card companies,” he says, “the better off you are.”

The New Waysto PayThe credit card is in decline. Here are a few hints of what might replace it. — D.R.

Twitpay

Type a friend’s Twitter handle, a dollar amount, and twitpay to transfer funds to their PayPal account.Zong

Instead of entering credit card information anew for every online purchase, users fill in their phone number and the charge shows up on their monthly bill.Square

The latest from Twitter cofounder Jack Dorsey, this 3/4-inch cube turns any iPhone into a credit card reader.GetGiving

In a world of virtual currencies, your wallet may never be the same.Illustration: Studio TonneMoney Over TimeA brief history of currency technology. —Bryan Gardiner640 BC: Coins Historians credit the Lydians of Asia Minor (now Turkey) with developing the first coins. Made of electrum — an amalgam of gold and silver — the innovation was promptly adopted by the Greeks, sparking a commercial revolution in the sixth century BC.This is the kind of revolutionary fervor that PayPal was always intended to foment. Peter Thiel, PayPal’s cofounder and a die-hard libertarian, launched the company as a means of creating a stateless monetary system, making it possible for anyone to switch, instantly and easily, between global currencies. “PayPal will give citizens worldwide more direct control over their currencies than they’ve ever had before,” he told new employees in 1999, according to the book The PayPal Wars. “It will be nearly impossible for corrupt governments to steal wealth from their people.”

But for most of its history, PayPal acted more as an enabler — a way of extending the credit card model of payment into the online realm — than as a bomb-thrower. Customers didn’t want to use PayPal to escape the tyranny of government currencies. They wanted to use it to spend money online without having to give out their credit card information to a million different vendors. By the turn of the millennium, PayPal pretty much operated as an online credit card company, charging vendors a percentage of every transaction to move funds from a buyer’s bank account to a seller’s bank account. Still, there were some hints of PayPal’s revolutionary capabilities. Unlike credit card companies, PayPal had no need to build and maintain an expensive digital network between vendors and banks around the world; it operated over the Internet. There was no need for a credit card reader, cutting point-of- sale system providers — and their vigorish — out of the equation. While credit card companies still paid fees to banks, a legacy from the days when they had to buy their cooperation, PayPal piggybacked on a communications system that enables digital transactions like direct deposits and automatic bill payment without charging a fee. Furthermore, PayPal users could keep their funds within their PayPal accounts, accruing interest and continuing to trade them with other PayPal users without ever once involving banks or anyone outside the PayPal ecosystem — a friction-free shadow economy in its own right. All of these advantages meant that PayPal could charge lower transaction fees than traditional credit card companies. That may have been a good business model, but it wasn’t exactly a game changer.

In recent years, many other companies have come up with their own PayPal-like innovations, creative tweaks to further squeeze some margins out of the traditional credit card model. Apple’s iTunes and Research in Motion’s payments program reduce transaction fees by bundling a customer’s purchases before sending them to a credit card company for processing. (That’s why you don’t usually see a series of 99-cent charges on your credit card bill; they are processed as one lump sum.) Virtual currencies, from Microsoft Points to Linden Dollars, encourage “in-world” trade, incurring credit card and banking fees only when their users buy in. By reducing their exposure to traditional transaction systems, these companies are able to wring extra pennies of profit out of each sale — which can aggregate into millions of dollars, turning their payment platforms into profit generators in their own right.

Money Over TimeA brief history of currency technology. —Bryan Gardiner800 AD: Paper A shortage of copper and the hassles of transporting heavy coins prompted China’s Tang dynasty to start issuing paper notes. Dubbed “flying cash,” this first paper-based money was used by merchants and the government.PayPal moved even further away from its revolutionary roots in 2002, when it was purchased by eBay for $1.5 billion. Suddenly the service, always a favored payment method on the site, became almost entirely focused on making auctions easier. Between 2005 and 2008, PayPal went from serving as the payment provider for 47 percent of eBay auctions to facilitating more than 60 percent (eBay expects it to hit around 75 percent by 2011). That was a fine strategy as long as eBay was growing. But in CEO Meg Whitman’s last years at the company’s helm, as the auction platform started to see a slowdown in revenue growth, it became clear to the PayPal team that it was time to get aggressive again. PayPal started working with outside vendors, and by 2007 it was transacting $47 billion worth of business a year — still a pittance compared to the trillions that moved through financial institutions. Scott Thompson, then PayPal’s CTO, started meeting with Osama Bedier, vice president of merchant services technology, and his team. How, Thompson asked, could PayPal capture more of that business?

Bedier’s team argued that PayPal’s users seemed to have plenty of ideas. They had long pushed for PayPal to expand into new businesses — payroll, invoicing, business-to-business money transfers. But building out any one of those services would take years, and the timing wasn’t right. Bedier pointed out that PayPal’s users had been responsible for many of the company’s most successful innovations: Users dragged PayPal onto eBay in the first place. (The company had initially resisted the move.) Other users cobbled together PayPal-enabled “tip jars”, which quickly spread across the blogosphere. What if the company opened up its code, embraced its developers, and turned its service into a platform? What if PayPal asked its users to create the tools and functions that would make it grow?

Thompson loved the idea in theory but was skeptical that Bedier’s team could pull it off. Thompson, who had recently left Visa, was hardly used to Silicon Valley’s freewheeling, experimental culture. With his Boston accent, bushy Cliff Clavin mustache, and fondness for pleated pants and button-down shirts, he looked like a dotcom engineer’s straightlaced father. “Where I come from, you can’t just let developers come in here and open accounts and move money around,” he says.

Illustration: Oliver MundayMoney Over TimeA brief history of currency technology. —Bryan Gardiner1949: Plastic When the check for dinner arrived, Frank McNamara realized he didn’t have enough cash to pay his bill. What the world needed, he realized, was an alternative to currency. One year later he returned to the same restaurant with what would become the first modern credit card, the Diners Club Card.Bedier was used to blasting through objections. Born in Cairo, he had spent a few years in Oregon as a preteen while his father earned a PhD. When the family moved back to Egypt, Bedier put together a plan to return to the US. He persuaded his father to have a friend, an IT manager at Oregon State University, take legal guardianship. Bedier never left the States again. Now he turned his powers of persuasion on Thompson. He said he would prove he could make a more open system work.

But first he had to figure out whether developers would play along. So in late 2007, he started on a road trip to meet with the people who were already building on PayPal’s limited open code. He met with more than 100 developers, most of whom were eager to help build an easier, more flexible system. PayPal had been requiring buyers and sellers to go through several steps to complete a transaction — go to its site, fill out forms, authenticate accounts. The developers envisioned something larger, a true digital currency that could be used on any Web site, that enabled money to move as easily as email: Send funds with a click, from and to anywhere and anyone on the Net.

In April 2008, Bedier led a meeting at eBay’s North First Street headquarters, where he presented his idea to CEO John Donahoe and his lieutenants. When Bedier was finished, he was stunned to get applause. “It was like a lightbulb clicked on,” Donahoe says. “I basically said, ‘You have unlimited funding.’ This is the highest-potential business I’ve ever seen in my career.”

Bedier hired executives from the banking and airline industries to help him design the platform. Soon other PayPal engineers were asking to be transferred to the project. They saw it as a return to PayPal’s original ambitions, when Peter Thiel and his cofounder Max Levchin sought to create an entirely new currency — not just a tool to help people sell used roller skates to one another. (In homage to this legacy, Bedier’s team called the project X.com, the name of Elon Musk’s payment company, which PayPal merged with back in 2000.) In November 2009, PayPal released the platform. In addition to the do-it-yourself ethos, X.com would sport a feature that should have terrified the traditional payment conglomerates: a new fee structure that charged vendors about one-third of what credit card companies were charging.

Whatever the future of payments looks like, it will probably be brought about by people like Christian Lanng. A tall and wide 31-year-old with a booming, operatic voice, Lanng is sitting on the couch of his venture backer’s house in Copenhagen. When he talks about the way banks and credit card companies process payments, he gets so upset that his entire body tenses and his voice rises until it’s echoing off the stark white walls. “This is the main battleground of capitalism!” he says. “This is the heart of it.”

Money Over TimeA brief history of currency technology. —Bryan Gardiner1995: Digital Cryptographer David Chaum wanted consumers to be able to transfer money digitally, just like banks. His ecash was an anonymous form of money first issued by an American bank in 1995. The company declared bankruptcy in 1998, but the concept has since been built upon by dozens of digital and virtual currencies.Lanng rests his MacBook on a tree-stump table in front of him. For the last seven months, he and a dozen or so other coders have been building an e-invoicing company called Porta. (At press time, Lanng was planning to rename the company TradeShift.) Already, the service has signed up two regions in northern Europe and one of the biggest cities in Brazil, but Lanng envisions something much bigger. He sees dynamic invoices that pay themselves — that constantly monitor exchange rates, say, or the price of lumber, and then automatically send out an order to withdraw funds or to make a purchase just when the price is cheapest. Most of the information is already available — there are plenty of databases that provide real-time pricing information, and he already has all of his clients’ account information and vital data. But Porta doesn’t have the technology or expertise to handle the transactions themselves. That’s why Lanng is coding with X.com.

For now, PayPal has shied away from using revolutionary rhetoric. In discussing its role, company executives sound less like Thiel, bent on overthrowing the system, and more like a would-be thief strolling through a jewelry store, determined to appear nonthreatening. (”We’re not an alternative to credit cards. We use credit cards in the PayPal wallet!” Donahoe says. “That’s part of the beauty of PayPal.”) And consumers, who have traditionally been shielded from credit card companies’ vendor fees and practices, may not care, or even notice, whether vendors use PayPal.

But even if PayPal never fires a shot, it is clear that people are looking for an alternative to credit cards. In 2009, US consumer credit card debt saw a sustained drop for the first time in decades, falling for 10 straight months as the recession took hold. Meanwhile, to fee-socked consumers struggling to make their payments, the credit card companies have become symbols of an uncaring, greedy bureaucracy. “As a longtime participant in the credit card industry, I’m interested to watch what’s going on right now, because credit card companies are actually yanking in credit, they’re raising fees, and people are choosing not to use credit cards,” says Jack Stephenson, PayPal’s head of strategy. “And the attitude a lot of people have about their credit card company is not a warm and fuzzy feeling right now. So I don’t think, at least anytime in the next three to five years, that PayPal needs to do anything to convince people not to use credit cards online. I think people will make that choice on their own.”

A generation ago, when people made the choice to switch to plastic, credit cards did not just replicate cash; they fundamentally changed how we used money. The ease with which people could make purchases encouraged them to buy much more than they had in the past. Entrepreneurs suddenly had access to easy — though high-interest — loans, providing a spark to the economy. Now, while it may be hard to predict what innovations PayPal’s platform will enable, it’s safe to say that the payment industry is going to change dramatically. As money becomes completely digitized, infinitely transferable, and friction-free, it will again revolutionize how we think about our economy.

The Federal Reserve Bank of New York today announced the beginning of a program to expand its counterparties for conducting reverse repurchase agreement transactions. This expansion is intended to enhance the capacity of such operations to drain reserves beyond what could likely be conducted through the New York Fed's traditional counterparties, the Primary Dealers. This announcement is pursuant to the October 19, 2009, Statement Regarding Reverse Repurchase Agreements, which announced that the New York Fed was studying the possibility of expanding its counterparties for these operations. The additional counterparties will not be eligible to participate in transactions conducted by the New York Fed other than reverse repos. This expansion of counterparties for the reverse repo program is a matter of prudent advance planning, and no inference should be drawn about the timing of any prospective monetary policy operation. The initial efforts of the New York Fed will be aimed at firms that typically provide large amounts of short-term funding to the financial markets. This approach will ensure that the Federal Reserve quickly achieves significant capacity for conducting reverse repo operations while allowing the Trading Desk at the New York Fed to utilize its current infrastructure for conducting and settling such operations. Over time, the New York Fed expects it will modify the counterparty criteria to include a broader set of counterparties.

The ultimate size and terms of reverse repo operations will depend on the directive from the Federal Open Market Committee to conduct such operations. In terms of operational details, the New York Fed anticipates that any transactions would be:offered to primary dealers and the broader set of counterparties,conducted at auction for a fixed (not floating) rate,settled through the tri-party repo system, and held against all major types of collateral in the System Open Market Account (SOMA), including Treasury securities, agency debt securities, and agency MBS securities.

Whenever the Fed decides to reduce reserves, it will have to sell its balance sheet assets to somebody for money. When the check written to the Fed clears against the buyer's bank that bank's reserves at the Fed will drop by the same amount. So that is the process the Fed will eventually follow if it does indeed begin to reduce bank reserves.

The Fed has certain "primary dealers" who, as I understand it, must buy Fed assets when they are offered for sale. I presume the primary dealers are buying for resale and, frankly, I don't know how prices are set between the Fed and the primary dealers.

Since the Fed now has a motley bunch of assets on its balance sheet for which it paid more than a trillion dollars, it apparently thinks it needs more "counterparties" who are able to buy such assets. I am not sure why they need a program to identify more buyers in advance; if those assets actually have some value I would think the Fed would only need to offer the assets and wait to see the bids. Maybe the Fed has some scheme which will press more institutions into the "must buy" role?

The "reverse repo" terminology also confuses me. If the Fed sells assets with a repurchase agreement, that would seem to imply only a short term reduction in reserves. A regular "repo" is used by the Fed to temporarily increase bank reserves -- buying an asset to increase reserves but with an agreement to sell it back in a short period of time, thereby reversing the earlier operation.

So ... let me add my voice to the growing chorus: how about a thorough explanation of this Fed announcement?

Securitization for DummiesHeidi is the proprietor of a bar in Detroit. She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with new marketing plan that allows her customers to drink now, but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi's "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flood into Heidi's bar. Soon she has the largest sales volume for any bar in Detroit. By providing her customers' freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi's gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi's borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don't really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar. He so informs Heidi.

Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since, Heidi cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS, and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community. The suppliers of Heidi's bar had granted her generous payment extensions and had invested their firms' pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately the bank, the brokerage houses, and their respective executives are saved and bailed out by a multi-billion dollar, no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who never have been in Heidi's bar.

Austrian Business Cycle Theory: A BriefExplanationDaily Article | Posted on 5/7/2001 by Dan MahoneyThe media’s favorite phony solution to the economic downturn is for theFed to drop interest rates lower and lower until the economy registers anupturn. What is wrong with this approach? Printing money—which is whatreducing interest rates below the market rate amounts to—is an artificialmeans of recovering from the very real effects of an artificial boom. Thispoint, however, is completely lost on most commentators, because theyhaven’t the slightest understanding of the Austrian theory of the businesscycle.This article gives a brief overview of the theory, which provides anexplanation of the recurrent periods of prosperity and recession that seem to plague capitalist societies. AsSalerno (1996) has argued, the Austrian business cycle theory is in many ways the quintessence of Austrianeconomics, as it integrates so many ideas that are unique to that school of thought, such as capital structure,monetary theory, economic calculation, and entrepreneurship. As such, it would be impossible to adequatelyexplain so rich a theory in a short note. (See Rothbard [1983] for greater details.) However, an attempt will bemade here to indicate how those relevant ideas come together in a unified framework.Man is confronted with a world of physical scarcity. That is, not all of our wants and needs, which are practicallylimitless, can be met. Outside of the Garden of Eden, we must produce in order to consume, and this means thatwe must combine our labor with whatever nature-given resources are available to us. As inherently rationalbeings, men have come to recognize many ways of solving this problem, such as peaceful cooperation under thedivision of labor leading to enhanced productivity, and private property rights permitting economic calculationso that different courses of action can be meaningfully compared.(This is not to say that man has perfect foresight and always correctly anticipates the outcome, good or bad, ofhis actions; only that man acts purposefully—and so always judges ex ante a course of action to lead to apreferred state of affairs—and is capable of distinguishing success from failure and acting accordingly.)However, it would help to consider the course of economic development from a simplified example, that of anisolated "Robinson Crusoe" situation. The circumstance faced here is that one must somehow combine one’slabor with available resources to produce goods for consumption (e.g., food, shelter, etc.). For example, I canpick berries by hand, and this will produce a certain level of consumption. However, if I wish to have a greaterlevel of consumption, I must create some means of increasing my berry collecting—for example, by building arod to knock berries from bushes and a net to collect them as they fall to the ground.Unless these means are nature-given, however, I must build them myself, and this will take time—time duringwhich I cannot pick and consume berries with my old method. Thus, during the time I am making my new,presumably more efficient, method, I must have some way of sustaining myself. This can only come about if Ihave saved (i.e., abstained from consuming) a sufficient amount of berries in the past, so that I may work onother approaches now. (For more on this process, see Rothbard [1993], ch. 1.)Let us be clear about what is happening here: One is not simply switching from consumption to production;rather, one is switching from one form of production to another. One cannot consume something until it has beenproduced, so all production processes involve foregoing consumption. The question, though, is what must bedone to switch to a supposedly more effective means of production.Obviously, if the rod-and-net system, presumably more productive, had required the same amount of time toconstruct as the hand-picking method, I would have engaged in this approach to begin with. Since acquiring theincreased productivity comes with a cost—namely, time spent away from using the old method to facilitateproduction and, thus, consumption—there must be some means of paying that cost.Of course, not all lengthier production processes are more productive. But at any given time, man alwayschooses those production processes that can produce a given amount of output for consumption in the shortestamount of time. A process that takes longer to arrive at the final stage of output will only be adopted if it iscorrespondingly more productive. In the Austrian conception, greater savings permit the creation of more"roundabout" production processes—that is, production processes increasingly far-removed from the finishedproduct. This is the role of savings, and we can ask what determines a particular level of savings.Time preference is the extent to which people value current consumption over future consumption. The key pointof the Austrian business cycle theory is that interventions in the monetary system—and there is some debate overwhat form those interventions must take to set in motion the boom-bust process—create a mismatch betweenconsumer time preferences and entrepreneurial judgments regarding those time preferences.Let us return to the Crusoe example above, and consider attempts to construct more productive means of berryextraction. What constrains me in this endeavor is my level of time preference. If I so enjoy current consumptionthat the thought of increased future consumption cannot sway me from foregoing sufficient berry-eating now,my rod-and-net system will not be built. In the context of fractional reserve banking, printing up berry-ticketscannot change this fact.As a numerical example, consider the case where hand-picking yields twelve berries a day, and I am simplyunwilling to go without less than ten berries per day. Suppose further that my time preference falls so that I amwilling to save two berries a day for seven days (leaving aside issues such as perishability, which obviously donot apply to a monetary economy). I will then have a reserve of fourteen berries. Assume I work one-fourth of aday on my new method of berry production and spend the remaining three-fourths of the day on producingberries with the old technique. The old method will give me nine berries a day, and I can use one berry from mysavings to meet my current consumption needs.If I can finish the rod-and-net system in fourteen days (the extent of my reserve), then everything is fine, and Ican go on to enjoy the fruits of my labor (no pun intended). If I misjudge however, and the process takes longerthan fourteen days, I must temporarily suspend production (or at least delay it) to fund my current consumption,as, by assumption, I value a certain level of current consumption over increased future consumption (the essenceof time preference). The point is, sufficient property must exist for me to lengthen the structure of production,and this property can only come from (past) savings. If my time preference does not enable sufficient property tobecome available for creating this production process, my efforts will end in failure.Lest it be thought this example is artificial, consider the situation where my needs are nine berries a day. Itwould appear that I can still work one-fourth of a day on the new technique without having a previous cache ofsavings, since the remaining three-fourths day of labor with the old method will meet those needs. Two thingsshould be noted, however. First, my time preference must first fall from a daily consumption of twelve berries tonine berries. Second, and this is the key point, had I saved previously, then I could spend that much more time onbuilding the new method, thus bringing it into increased production of berries that much sooner. Savings remainkey to this process of capital construction, and savings are driven by time preference. Indeed, time preferencemanifests itself in savings.This same process of using savings to fund current production for future consumption goes on in more complexeconomies. (Of course, with the introduction of more than one individual, recognition of increased productivityunder the division of labor becomes possible, thus raising man above the subsistence level and making possible apool of savings.) At any given time, the individuals in society are engaged in production to meet some "level" ofconsumption needs. In order for more lengthy—and, hence, if they are to be maintained, more productive—processes to be entered into, it is necessary that some individuals have refrained from consumption in the past sothat other individuals may be sustained and facilitated in assembling this new structure, during which theycannot produce—and thus, not consume—consumption goods with the methods of the old structure.The thrust of the Austrian theory of the business cycle is that credit inflation distorts this process, by making itappear that more means exist for current production than are actually sustainable (at least in some renditions; seeHülsmann [1998] for a "non-standard" exposition of ABCT). Since this is in fact an illusion (printing claims toproperty ["inflation"] is not the same thing as actually having property; see Hoppe et al. [1998]), the endeavorsof entrepreneurs to create a structure of production not reflecting actual consumer time preferences (asmanifested in available savings for the purchase of producer goods) must end in failure.Any kind of economy above the most primitive does not, of course, engage in barter, but rather uses money as amedium of exchange to overcome the problem of the absence of a double coincidence of wants. It must bestressed, though, that apart from this unique role, money is itself a good, the most marketable good. To be sure,money is valuable to the extent that others are willing to accept it in exchange. However, money itself must firsthave originated as a directly serviceable good before it could become an indirectly serviceable good (i.e.,money). This is the thrust of Mises's regression theorem (Mises [1981]; Rothbard [1993], ch. 4).Like any other exchange, one may find after the fact that it was not to one's liking; for example, one may findthat the money good is no longer accepted by "society." There is nothing unique about money in these respects.What is unique about money is its use in economic calculation. Since all exchanges are, ultimately, exchangesinvolving property, a common unit for comparing such exchanges is indispensable. In particular, the amount ofmoney as savings represents a "measure" of the amount of property available for production processes. (Indeed,to even maintain a given structure of production requires some abstinence from consumption, so that productiondedicated to maintenance instead of consumption may be undertaken.)Holding cash (in your wallet, in a tin can in the backyard, etc.) is not a form of saving. Cash balances canincrease without time preferences decreasing, as they do when one saves. (In fact, one saves because one's timepreference falls.) One can increase one's cash balances by decreasing one's spending on consumer AND producergoods. To save is to decrease one's spending on consumer goods and increase one's spending on producer goods.The fact that saving usually involves an intermediary (i.e., a bank) to permit someone else to spend on producergoods does not change this fact. Money is inherently a present good; holding it "buys" alleviation from acurrently felt uneasiness about an uncertain future. (See Hoppe [1994] and Hoppe et al. [1998] for a discussionof the nature of money.) Lending out demand deposits, or claims to current goods, cannot facilitate the purchaseof producer goods (for the creation of future goods at the expense of current goods), apart from the juridicalissues involved.The crucial thing about money is that it permits economic calculation, the comparison of anticipated revenuesfrom an action with potential costs in a common unit. That is, one acquires property based on a judgment of thefuture by exchanging other property, and this is impossible—or, rather, meaningless—to do without a commonunit for comparing alternatives. Money is property, and under a monetary system which makes it appear thatmore property exists for production than actually exists, failure is inevitable.One need not focus on whether entrepreneurs correctly "read" interest rates or not. Entrepreneurs makejudgments about the future and, of course, can always potentially be in error; success cannot be known now.However, judgments will be in error when one is confronted with the illusion of a greater pool of savings thanactual consumer time preferences would justify. This is precisely the situation established by the bankingsystem—as intermediaries between savers and producers, or "investors"—as currently exists in the Westernworld. The system ensures error, though of course it does not preclude success; thus, the existence of genuineeconomic growth alongside malinvestments.This analysis is not a moralistic insistence that an economy be ultimately founded on something "real." It is arecognition that mere subjective wants cannot will more property into existence than actually exists. Should amonetary system give the illusion that the time preferences of consumers, as providers of property for productionpurposes, is smaller than it actually is, then the structure of production thus assembled in such a system isinherently in error. Whatever plans appear to be feasible during the early phase of a boom will, of necessity,eventually be revealed to be in error due to a lack of sufficient property. This is the crux of the Austrian businesscycle theory.------Dan Mahoney, Ph,D., mathematics, works for Mirant-Americas. danm@iopener.netReferencesHoppe, Hans-Hermann, 1994, "How is Fiat Money Possible? - or, The Devolution of Money and Credit," Reviewof Austrian Economics, 7, 2.Hoppe, Hans-Hermann, Jörg Guido Hülsmann, and Walter Block, 1998, "Against Fiduciary Media," QuarterlyJournal of Austrian Economics, 1, 1.Hülsmann, Jörg Guido, 1997, "Knowledge, Judgment, and the Use of Property," Review of Austrian Economics,10, 1.Hülsmann, Jörg Guido, 1998, "Toward a General Theory of Error Cycles," Quarterly Journal of AustrianEconomics, 1, 4.Mises, Ludwig von, 1981, The Theory of Money and Credit, Liberty Fund.Rothbard, Murray N., 1983, America's Great Depression, Richardson and Snyder.Rothbard, Murray N., 1993, Man, Economy, and State, Ludwig von Mises Institute.Salerno, Joseph T., 1996, Austrian Economics Newsletter, Fall 1996.See also The Austrian Theory of the Trade Cycle Study Guide .

Ten Economic Blunders from History 5. No Smuggling AllowedPrice controls are stupid anytime, but it takes true idiocy to apply them in the middle of a siege. In 1584 forces controlled by Alexander Farnese, the duke of Parma, were besieging Holland's grandest city, Antwerp, in the Dutch War of Independence. At first the siege was ineffectual because the duke's lines were porous and Antwerp could be supplied by sea, but the duke was in luck because the city decided to blockade itself voluntarily. The magistrates of the city declared a maximum on the price of grain. The smugglers who had been running the blockade up to that point became considerably less enthusiastic about making food deliveries after that. Facing starvation, the city surrendered the next year.

As they prepare for holiday reading in Tuscany, City bankers are buying up rare copies of an obscure book on the mechanics of Weimar inflation published in 1974.By Ambrose Evans-Pritchard

Ebay is offering a well-thumbed volume of "Dying of Money: Lessons of the Great German and American Inflations" at a starting bid of $699 (shipping free.. thanks a lot).

The crucial passage comes in Chapter 17 entitled "Velocity". Each big inflation -- whether the early 1920s in Germany, or the Korean and Vietnam wars in the US -- starts with a passive expansion of the quantity money. This sits inert for a surprisingly long time. Asset prices may go up, but latent price inflation is disguised. The effect is much like lighter fuel on a camp fire before the match is struck.

People’s willingness to hold money can change suddenly for a "psychological and spontaneous reason" , causing a spike in the velocity of money. It can occur at lightning speed, over a few weeks. The shift invariably catches economists by surprise. They wait too long to drain the excess money.

"Velocity took an almost right-angle turn upward in the summer of 1922," said Mr O Parsson. Reichsbank officials were baffled. They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply. He contends that public patience snapped abruptly once people lost trust and began to "smell a government rat".

Some might smile at the Bank of England "surprise" at the recent the jump in Brtiish inflation. Across the Atlantic, Fed critics say the rise in the US monetary base from $871bn to $2,024bn in just two years is an incendiary pyre that will ignite as soon as US money velocity returns to normal.

Morgan Stanley expects bond carnage as this catches up with the Fed, predicting that yields on US Treasuries will rocket to 5.5pc. This has not happened so far. 10-year yields have fallen below 3pc, and M2 velocity has remained at historic lows of 1.72.

As a signed-up member of the deflation camp, I think the Bank and the Fed are right to keep their nerve and delay the withdrawal of stimulus -- though that case is easier to make in the US where core inflation has dropped to the lowest since the mid 1960s. But fact that O Parsson’s book is suddenly in demand in elite banking circles is itself a sign of the sort of behavioral change that can become self-fulfilling.

As it happens, another book from the 1970s entitled "When Money Dies: the Nightmare of The Weimar Hyper-Inflation" has just been reprinted. Written by former Tory MEP Adam Fergusson -- endorsed by Warren Buffett as a must-read -- it is a vivid account drawn from the diaries of those who lived through the turmoil in Germany, Austria, and Hungary as the empires were broken up.

Near civil war between town and country was a pervasive feature of this break-down in social order. Large mobs of half-starved and vindictive townsmen descended on villages to seize food from farmers accused of hoarding. The diary of one young woman described the scene at her cousin’s farm.

"In the cart I saw three slaughtered pigs. The cowshed was drenched in blood. One cow had been slaughtered where it stood and the meat torn from its bones. The monsters had slit the udder of the finest milch cow, so that she had to be put out of her misery immediately. In the granary, a rag soaked with petrol was still smouldering to show what these beasts had intended," she wrote.

Grand pianos became a currency or sorts as pauperized members of the civil service elites traded the symbols of their old status for a sack of potatoes and a side of bacon. There is a harrowing moment when each middle-class families first starts to undertand that its gilt-edged securities and War Loan will never recover. Irreversible ruin lies ahead. Elderly couples gassed themselves in their apartments.

Foreigners with dollars, pounds, Swiss francs, or Czech crowns lived in opulence. They were hated. "Times made us cynical. Everybody saw an enemy in everybody else," said Erna von Pustau, daughter of a Hamburg fish merchant.

Great numbers of people failed to see it coming. "My relations and friends were stupid. They didn’t understand what inflation meant. Our solicitors were no better. My mother’s bank manager gave her appalling advice," said one well-connected woman.

"You used to see the appearance of their flats gradually changing. One remembered where there used to be a picture or a carpet, or a secretaire. Eventually their rooms would be almost empty. Some of them begged -- not in the streets -- but by making casual visits. One knew too well what they had come for."

Corruption became rampant. People were stripped of their coat and shoes at knife-point on the street. The winners were those who -- by luck or design -- had borrowed heavily from banks to buy hard assets, or industrial conglomerates that had issued debentures. There was a great transfer of wealth from saver to debtor, though the Reichstag later passed a law linking old contracts to the gold price. Creditors clawed back something.

A conspiracy theory took root that the inflation was a Jewish plot to ruin Germany. The currency became known as "Judefetzen" (Jew- confetti), hinting at the chain of events that would lead to Kristallnacht a decade later.

While the Weimar tale is a timeless study of social disintegration, it cannot shed much light on events today. The final trigger for the 1923 collapse was the French occupation of the Ruhr, which ripped a great chunk out of German industry and set off mass resistance.

Lloyd George suspected that the French were trying to precipitate the disintegration of Germany by sponsoring a break-away Rhineland state (as indeed they were). For a brief moment rebels set up a separatist government in Dusseldorf. With poetic justice, the crisis recoiled against Paris and destroyed the franc.

The Carthaginian peace of Versailles had by then poisoned everything. It was a patriotic duty not to pay taxes that would be sequestered for reparation payments to the enemy. Influenced by the Bolsheviks, Germany had become a Communist cauldron. partakists tried to take Berlin. Worker `soviets' proliferated. Dockers and shipworkers occupied police stations and set up barricades in Hamburg. Communist Red Centuries fought deadly street battles with right-wing militia.

Nostalgics plotted the restoration of Bavaria’s Wittelsbach monarchy and the old currency, the gold-backed thaler. The Bremen Senate issued its own notes tied to gold. Others issued currencies linked to the price of rye.

This is not a picture of America, or Britain, or Europe in 2010. But we should be careful of embracing the opposite and overly-reassuring assumption that this is a mild replay of Japan’s Lost Decade, that is to say a slow and largely benign slide into deflation as debt deleveraging exerts its discipline.

Japan was the world’s biggest external creditor when the Nikkei bubble burst twenty years ago. It had a private savings rate of 15pc of GDP. The Japanese people have gradually cut this rate to 2pc, cushioning the effects of the long slump. The Anglo-Saxons have no such cushion.

There is a clear temptation for the West to extricate itself from the errors of the Greenspan asset bubble, the Brown credit bubble, and the EMU sovereign bubble by stealth default through inflation. But that is a danger for later years. First we have the deflation shock of lives. Then -- and only then -- will central banks go too far and risk losing control over their printing experiment as velocity takes off. One problem at a time please.

Dr. Keynes Killed the PatientBy Michael PentoA morbidly obese gentleman labored into Dr. Hayek's office suffering from severe chest pain. The patient also complained that he was unable to consume his usual 10,000 calorie-per-day diet; in fact, he was feeling so sick that he could barely scarf down 9,000 calories. He noted that his love for food remained as strong as ever, but his body just wasn't keeping up with his demands.

After having a thorough look at the patient, the good doctor could not find anything wrong outside of the patient's extreme portliness. After a moment of reflection, he delivered to his patient a troubling diagnosis. He explained that the chest pain stemmed from the strain the patient's 500lb body was putting on his heart, and that the lack of appetite was his body's attempt to protect itself from this imbalance. Dr. Hayek's prescription was simple: the patient had to dramatically reduce his consumption while undertaking a moderate exercise program, with the goal of losing 250lbs as quickly and safely as possible. Dr. Hayek was aware that it would be a physically painful and emotionally difficult process for the man, but it was the only way to avert a life of suffering - or even a heart attack.

Unfortunately, our patient rebelled against such an austere program. He had grown very fond of his high-calorie and high-fat diet and didn't think that now, when he was already depressed from dealing with all these ailments, was a good time to deny himself the few pleasures he had left. In his opinion, the doc's prescription was just too simplistic. He thought there just had to be a way to have his cake and eat it - frequently. So, he waddled out of Dr. Hayek's office as fast as he could, shouting over his shoulder: "I'm getting a second opinion!"

The overweight gentleman sauntered across the street, where he found the office of Dr. Keynes. He told the new doctor about his acute chest pain and lack of appetite, and complained about the previous doctor's "heartless" prescription. After a cursory examination, Dr. Keynes rendered his diagnosis: the patient's condition did not stem from the fact that his gigantic frame was causing undo strain on his heart; instead, the doctor concluded, the patient's chest pain was merely causing a temporary lack of hunger.

Furthermore, Dr. Keynes argued, the stress of cutting weight at the present time would certainly prove detrimental to the man's already weak heart. Therefore, his prescription was for the 500lb man to each as much as possible, as quickly as possible. Anything less might cause the man to suffer a heart attack, he noted. Now the doctor did concede that, at some point in the distant future, it might be a good idea for the man to shed a few pounds. But for the present, the most import thing to do would be to consume as much as he could stomach.

The patient left Dr. Keynes' office with a broad smile. After gorging at an all-you-can-eat buffet, he momentarily forgot about his chest pain. It looked like he had found his solution; except, a week later, he died.

The Hubris of Government

The allegory above discusses the dangers of quackery, whether medical or economic. Right now, economic quackery - in the form of Keynesianism - has overtaken Washington.

American consumers are trying their best to deleverage. In terms of the story, the patient is actually trying to lose weight. But the government is blocking deleveraging and trying to boost consumption. They are forcing food down the patient's throat. According to the Flow of Funds Report, households reduced debt at a 2.4% annualized rate ($330 billion) during Q1 of 2010. Meanwhile, the federal government was piling on debt at an 18.5% annual rate ($1.44 trillion). Since every dollar of government debt is a promise to tax the private sector in the future with interest, this public spending spree effectively negated the Herculean efforts of the private sector to return to a sustainable path.

That's where the arrogance of Washington is really apparent. Scores of millions of American consumers have made the decision that reducing their debt burden is in their best interests right now. But a few hundred individuals in government believe they know better than the collective wisdom of the entire free market. By leveraging up the public sector, they have used their power to confiscate our savings. In short, they are forbidding us from following the common sense path to fiscal health.

Unlike their forbears, modern-day Keynesians do not argue just for mollification in the rate of deleveraging. They seek to significantly increase debt levels in an effort to boost the aggregate demand in the economy. Apparently, only once the mythical recovery takes hold due to government spending, printing, and borrowing does a discussion of deficits become appropriate.

The US has persisted under this theory for close to a century, though with a declining quality of life. Unfortunately, the patient has now gone critical. Curiously, the world has yet to fully recognize our precarious condition, even as they provide us with life support. Washington is now entirely dependent on the reserve currency status of the dollar and the continued hibernation of bond vigilantes. Without these supports, the United States would face complete economic arrest.

Rather than allowing the American people to get back on our feet, Washington is stuffing us with even more debt. It's almost as if the feds are daring our foreign creditors to pull the plug. As a consequence, I predict that just as Dr. Keynes killed his patient, Keynesian economics will kill our economy.

Great post / analogy Crafty! Our economy burdened with mandates, taxes, spending and regulations is so obese that we cannot reach down to tie our own shoes. Posted under govt. spending is the new analysis that the public sector is eating up 63.4% of the resources available in the economy. Answer: more spending, seriously. It does not even mischaracterize the thought process of the ruling regime and their thought leaders. Amazingly, the same day you posted Dr. Hayek and Dr. Keynes, Paul Krugman wrote another column poking fun at "austerians" and calling for even more government largess - I kid you not.

Dr. Krugman, we are not worshipping the bond Gods, we are just noticing and frightened by the fact that the public sector is consuming all of the oxygen in the room. If we are living beyond our needs today, we will necessarily be living BENEATH our means tomorrow. The current budget is $4 trillion, $2.5 trillion in revenues, 1.5 trillion in new debt added per year, with accumulating interest. To spend below $4 trillion would be "human sacrifice". The economic growth we have acquired from this Keynesian stimulus is ZILCH, well below the 3.1% or so that the economy requires. I think this is one of those math or word problems where the uncluttered mind of a kindergardner can answer it more accurately than a Nobel prize winning economist - with an agenda. Note where Obama gets his straw man argument style from, if we cut back (at all) on government spending it means we are giving up on job creation!

As I look at what passes for responsible economic policy these days, there’s an analogy that keeps passing through my mind. I know it’s over the top, but here it is anyway: the policy elite — central bankers, finance ministers, politicians who pose as defenders of fiscal virtue — are acting like the priests of some ancient cult, demanding that we engage in human sacrifices to appease the anger of invisible gods.

Hey, I told you it was over the top. But bear with me for a minute.

Late last year the conventional wisdom on economic policy took a hard right turn. Even though the world’s major economies had barely begun to recover, even though unemployment remained disastrously high across much of America and Europe, creating jobs was no longer on the agenda. Instead, we were told, governments had to turn all their attention to reducing budget deficits.

Skeptics pointed out that slashing spending in a depressed economy does little to improve long-run budget prospects, and may actually make them worse by depressing economic growth. But the apostles of austerity — sometimes referred to as “austerians” — brushed aside all attempts to do the math. Never mind the numbers, they declared: immediate spending cuts were needed to ward off the “bond vigilantes,” investors who would pull the plug on spendthrift governments, driving up their borrowing costs and precipitating a crisis. Look at Greece, they said.

The skeptics countered that Greece is a special case, trapped by its use of the euro, which condemns it to years of deflation and stagnation whatever it does. The interest rates paid by major nations with their own currencies — not just the United States, but also Britain and Japan — showed no sign that the bond vigilantes were about to attack, or even that they existed.

Just you wait, said the austerians: the bond vigilantes may be invisible, but they must be feared all the same.

This was a strange argument even a few months ago, when the U.S. government could borrow for 10 years at less than 4 percent interest. We were being told that it was necessary to give up on job creation, to inflict suffering on millions of workers, in order to satisfy demands that investors were not, in fact, actually making, but which austerians claimed they would make in the future.

But the argument has become even stranger recently, as it has become clear that investors aren’t worried about deficits; they’re worried about stagnation and deflation. And they’ve been signaling that concern by driving interest rates on the debt of major economies lower, not higher. On Thursday, the rate on 10-year U.S. bonds was only 2.58 percent.

So how do austerians deal with the reality of interest rates that are plunging, not soaring? The latest fashion is to declare that there’s a bubble in the bond market: investors aren’t really concerned about economic weakness; they’re just getting carried away. It’s hard to convey the sheer audacity of this argument: first we were told that we must ignore economic fundamentals and instead obey the dictates of financial markets; now we’re being told to ignore what those markets are actually saying because they’re confused.

And, yes, we are talking about sacrifices. Anyone who doubts the suffering caused by slashing spending in a weak economy should look at the catastrophic effects of austerity programs in Greece and Ireland.

Maybe those countries had no choice in the matter — although it’s worth noting that all the suffering being imposed on their populations doesn’t seem to have done anything to improve investor confidence in their governments.

But, in America, we do have a choice. The markets aren’t demanding that we give up on job creation. On the contrary, they seem worried about the lack of action — about the fact that, as Bill Gross of the giant bond fund Pimco put it earlier this week, we’re “approaching a cul-de-sac of stimulus,” which he warns “will slow to a snail’s pace, incapable of providing sufficient job growth going forward.”

It seems almost superfluous, given all that, to mention the final insult: many of the most vocal austerians are, of course, hypocrites. Notice, in particular, how suddenly Republicans lost interest in the budget deficit when they were challenged about the cost of retaining tax cuts for the wealthy. But that won’t stop them from continuing to pose as deficit hawks whenever anyone proposes doing something to help the unemployed.

So here’s the question I find myself asking: What will it take to break the hold of this cruel cult on the minds of the policy elite? When, if ever, will we get back to the job of rebuilding the economy?

http://www.ustreas.gov/press/releases/hp673.htm50% move up and out of the lower quintile in just 10 years. Please watch for misleading quintile analyses that don't chart the improvement and movement of individuals in the economy. This Treasury data refutes the claim that only the rich got richer.

November 13, 2007

Treasury Releases Income Mobility Study

Washington DC--The Treasury Department today released a study on income mobility of U.S. taxpayers from 1996 through 2005.

The study showed that, just as in the previous 10-year period, a majority of American taxpayers move from one income group to another over time. The study also recognizes that the dynamism of the U.S. economy significantly contributes to income mobility.

The key findings of the study included:

* Income mobility of individuals was considerable in the U.S. economy during the 1996 through 2005 period with roughly half of taxpayers who began in the bottom quintile moving up to a higher income group within 10 years. * About 55 percent of taxpayers moved to a different income quintile within 10 years. * Among those with the very highest incomes in 1996--the top 1/100 of one percent--only 25 percent remained in the group in 2005. Moreover, the median real income of these taxpayers declined over the study period. * The degree of mobility among income groups is unchanged from the prior decade (1987 through 1996). * Economic growth resulted in rising incomes for most taxpayers over the study period: * Median real incomes of all taxpayers increased by 24 percent after adjusting for inflation; * Real incomes of two-thirds of all taxpayers increased over this period; and * Median incomes of those initially in the lower income groups increased more than the median incomes of those initially in the high income groups.